On March 25, 2014, the U.S. Supreme Court unanimously ruled that severance payments may be subject to tax under the Federal Insurance Contributions Act (FICA). United States v. Quality Stores, 12-1408.
Quality Stores Inc., an agricultural specialty retailer based in Michigan, made severance payments to employees who were involuntarily terminated as part of a Chapter 11 bankruptcy. These payments – which were made pursuant to plans that did not tie payments to the receipt of state unemployment insurance – varied based on job seniority and time served. Quality Stores paid and withheld the disputed taxes under FICA. Later believing that the payments should not have been taxed as wages under FICA, Quality Stores sought a refund on behalf of itself and about 1,850 former employees. When the IRS did not allow or deny the refund, Quality Stores initiated proceedings in the bankruptcy court, which granted summary judgment in its favor. The district court and Sixth Circuit affirmed, concluding that severance payments are not wages under FICA.
The Supreme Court unanimously reversed (without Justice Kagan, who was recused). Writing for the Court, Justice Anthony Kennedy stated that the Sixth Circuit incorrectly relied on §3402(o) of the Internal Revenue Code (IRC), a provision governing income tax withholding, rather than on FICA’s definition of wages. The Court determined that FICA broadly defines wages to include compensation for services of any type. Severance payments fit this definition, as they are a form of remuneration made only to employees in consideration for employment. This is particularly clear where the severance payments vary according to a terminated employee’s function and seniority, as “service” “mea[ns] not only work actually done but the entire employer–employee relationship for which compensation is paid.” The Court further concluded that IRC §3402(o) does not narrow the term “wages” under FICA to exempt all severance payments.
Here, the severance payments were made to employees terminated against their will, were varied based on job seniority and time served, and were not linked to the receipt of state unemployment benefits. Therefore, the Court reversed the Sixth Circuit and remanded, holding that under FICA’s broad definition of wages, these severance payments constitute taxable wages.
In reaching this decision, the Court noted the narrow nature of the question before it. The Court explained that the IRS provides that severance payments tied to the receipt of state unemployment benefits are exempt from income-tax withholding and also from FICA taxation. But because the severance payments here were not linked to state unemployment benefits, the Court did not consider the question whether the IRS’ current exemption is consistent with the broad definition of wages under FICA.