Reversing a decision by the Sixth Circuit Court of Appeals, the U.S. Supreme Court ruled unanimously that severance payments to employees who were involuntarily terminated as part of a Chapter 11 bankruptcy were taxable wages subject to Social Security and Medicare (FICA) taxes. The decision disappointed many who had hoped the court would uphold the earlier appeals court ruling that certain severance payments should be exempt from FICA taxes as supplemental unemployment compensation benefits (SUBs).

Entering bankruptcy proceedings in 2001, Quality Stores, Inc. terminated thousands of employees as part of a reduction in work force or discontinuance of a plant or operation. Quality provided them with severance payments under two different termination plans. The company reported the severance as W-2 wages, paying the employer’s share of FICA taxes and withholding the employees’ share of FICA taxes on the severance. On behalf of itself and about 1,850 former employees, Quality then filed for a refund of over $1 million in FICA taxes. When the IRS declined to rule on the claim, Quality sought a refund of the disputed amount through the bankruptcy court. The bankruptcy court granted summary judgment in favor of Quality, a decision that was later affirmed by a district court and the Sixth Circuit. All concluded that severance payments are not “wages” under FICA.

Following the Sixth Circuit decision, numerous companies filed protective refund claims for FICA taxes incurred on severance payments made as part of a workforce reduction, hoping for a favorable ruling by the high court that would require the IRS to provide refunds on their FICA tax payments. In denying the FICA tax exemption, the Supreme Court focused on the nature of severance, noting that severance payments made to terminated employees are “remuneration for employment.” Moreover, the severance payments in this case varied based on job seniority and time served and were not linked to the receipt of state unemployment benefits. Discussing the historical treatment by the IRS of SUB and severance payments, the court rejected Quality’s argument that the tax code mandates that severance payments are to be deemed wages for purposes of income-tax withholding but are not subject to FICA taxation. Opinions vary on the larger effects of the decision, especially with respect to severance payments tied to state unemployment benefits, but Quality and its former employees will receive no refund from the IRS on the FICA taxes paid on their severance. (United States v. Quality Stores, Inc., U.S. 2014)