U.S. Supreme Court rules that severance payments are taxable wages

The U.S. Supreme Court has recently ruled that severance payments are taxable wages under the Federal Insurance Contributions Act (FICA).  In a unanimous decision issued on March 25, 2014, the Court overturned a decision of the U.S. Court of Appeals for the 6th Circuit, which had earlier ruled that severance payments are not taxable wages.  The lower court had relied upon the section of the Internal Revenue Code governing income tax withholding instead of FICA’s definition of wages.  In United States v. Quality Stores, No. 12-1408, the Supreme Court determined that the lower court’s ruling was incorrect.

The Supreme Court’s decision reaffirms that severance paid to employees in lump sums is taxable as wages for both income tax withholding and FICA purposes. The court noted that the IRS still exempts severance payments tied to receipt of state unemployment benefits from income tax and FICA withholding.  However, in most situations employers typically do not meet the IRS requirements for the pay to be considered state unemployment benefits.

In the case at hand, Quality Stores terminated the employment of thousands of employees as it was going into bankruptcy.  It made severance payments that were tied to work to various categories of employees including its CEO, senior managers and other employees.  Quality Stores reported the severance payments on W-2 tax forms, paid the employer’s required share of FICA taxes and withheld employees’ share of these taxes.  

Subsequently, on behalf of many of those employees, the company filed with the IRS for a refund of those taxes.  It was the company’s position that the income tax withholding provisions of the IRS limited the definition of “wages” so as not to include the severance payments made by the company.  When the IRS did not respond, Quality Stores filed for a refund in Bankruptcy Court, which granted the request.  Litigation ensued and ultimately the Court of Appeals for the 6th Circuit affirmed the decision, concluding that the severance payments made by the company were not wages under FICA.

On appeal, the Supreme Court overruled the Circuit Court, finding that under the FICA definition of “wages,” the severance payments made to terminated employees and not linked to the receipt of state unemployment benefits were remuneration for employment.