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Supreme Court Holds That Severance Payments Are FICA Wages.
(Parker Tax Publishing March 27, 2014)

Generally, all compensation for employment is considered wages subject to tax under the Federal Insurance Contributions Act (FICA), unless it is specifically excluded. Thus, salaries, bonuses, fees, commissions, and similar items are FICA wages if paid as compensation for employment. Further, IRS regulations state that unless an exception applies, compensation for an employee's services constitutes wages even though at the time the compensation is paid, the employer/ employee relationship no longer exists.

In view of the broad definition of FICA wages, it came as a bit of a surprise when, in a 2012 case, the Sixth Circuit held that severance payments made to employees terminated against their will were not wages taxed by FICA. To reach its holding, the Sixth Circuit relied not on FICA's definition of wages, but on Code Sec. 3402(o), a provision governing income tax withholding. The Sixth Circuit's decision on the issue of whether Code Sec. 3402(o) may apply to exclude severance pay from FICA wages created a split in the circuits. In CSX Corp. v. U.S., 518 F.3d 1328 (Fed. Cir. 2008), reversing 32002 PTC 31 (Fed.Cl. 2002), the Federal Circuit held that Code Sec. 3402(o) does not apply for that purpose.

The U.S. Supreme Court has now held in U.S. v. Quality Stores, Inc. 2014 PTC 151 (3/25/14) that the Sixth Circuit's conclusion was incorrect, and that the severance pay at issue was subject to FICA tax.


Quality Stores, Inc., entered bankruptcy proceedings in 2001. Before and after the filing of an involuntary Chapter 11 bankruptcy petition, Quality Stores made severance payments to employees who were involuntarily terminated as a result of a reduction in work force or discontinuance of a plant or operation. The severance payments varied based on job seniority and time served, and were made under plans that did not tie payments to the receipt of state unemployment insurance. Quality Stores paid and withheld FICA taxes on the severance payments. 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 the severance payments are not wages under FICA.

Sixth Circuit's Analysis

Code Sec. 3402(o)(2) defines supplemental unemployment compensation benefits, or "SUB payments," as an amount that is paid to an employee under an employer's plan because of the employee's involuntary separation from employment resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions and that is included in the employee's gross income. The Sixth Circuit determined that the severance payments at issue constituted SUB payments under that definition and as such were not taxable wages under FICA.

The heading to Code Sec. 3402(o)(1) reads, "Extension of withholding to certain payments other than wages." Further, Code Sec. 3402(o)(1)(A) provides that for purposes of Chapter 24 of the Code (relating to income tax withholding), any SUB payments paid to an individual are to be treated as if they were payments of wages by an employer to an employee for a payroll period.

The Sixth Circuit recognized the FICA definition of wages, unlike the definition of wages for federal income tax withholding purposes, does not expressly include or exclude SUB payments; nor do the FICA regulations address the subject. However, the court viewed the instruction in Code Sec. 3402(o) that SUB payments are to be treated "as if" they were wages for income tax withholding purposes as implying that Congress did not consider SUB payment to be wages; rather, Congress allowed SUB payments to be treated as wages to facilitate federal income tax withholding on those payments, thereby alleviating final tax payment problems for employees. In light of this "clear congressional intent," the Sixth Circuit approved the bankruptcy court's reasoning that if SUB payments are not wages but are only treated as if they were wages for purposes of federal income tax withholding, then SUB payments also are not wages under the nearly identical definition of wage found in the FICA provisions.

Supreme Court's Analysis

The Supreme Court held that the severance payments at issue in Quality Stores are taxable wages for FICA purposes. The Court noted that Code Sec. 3121(a) defines "wages" broadly as all remuneration for employment. The Court found that, as a matter of plain meaning, severance payments fit this definition: They are a form of remuneration made only to employees in consideration for employment. Code Sec. 3121(b) defines "employment" as any service performed by an employee for an employer. Citing its decision in Social Security Bd. v. Nierotko, 327 U. S. 358 (1946), the Court stated that, by varying severance payments according to a terminated employee's function and seniority, the severance payments at issue confirmed the principle that "service" means not only work actually done, but the entire employer-employee relationship for which compensation is paid. According to the Court, this broad definition of wages is reinforced by the specificity of FICA's lengthy list of exemptions. For example, the exemption for severance payments made because of retirement for disability under Code Sec. 3121(a)(13)(A), would be unnecessary if severance payments generally were not considered wages.

The Court found that FICA's statutory history sheds further light on the definition of wages. FICA originally contained definitions of "wages" and "employment" identical in substance to the current ones, but in 1939, Congress excepted from wages dismissal payments not legally required by the employer. Since that exception was repealed in 1950, FICA has contained no general exception for severance payments.

The Court also found that the Code provisions governing income tax withholding do not limit the meaning of wages for FICA purposes. Like the Code's FICA provisions, Code Sec. 3401(a) has a broad definition of "wages" and contains a series of specific exemptions. Code Sec. 3402(o) says that supplemental unemployment compensation benefits or SUB payments, which include severance payments, are to be treated "as if" they were wages. Contrary to the Sixth Circuit's and Quality Stores' reading, this "as if" instruction does not mean that severance payments fall outside the definition of wages for income-tax withholding purposes and, in turn, are not covered by FICA's definition. Nor can Quality Stores rely on the heading of Code Sec. 3402(o), which refers to "certain payments other than wages." The Court found that the heading to Code Sec. 3402(o) falls short of declaring that all the payments listed in Code Sec. 3402(o) are "other than wages." Instead, Code Sec. 3402(o) must be understood in terms of the regulatory background against which it was enacted.

In the 1950's and 1960's, because some states provided unemployment benefits only to terminated employees not earning wages, IRS rulings took the position that severance payments tied to the receipt of state benefits were not wages. To address the problem that severance payments were still considered taxable income, which could lead to a large year-end tax liability for terminated workers, Congress enacted Code Sec. 3402(o), which treats both SUB payments and severance payments that the IRS considered wages "as if" they were wages subject to withholding.

OBSERVATION: Although Code Sec. 3402(o) does not provide a basis for excluding severance pay from FICA wages as SUB payments, the IRS has provided an administrative exemption that excludes certain supplemental unemployment benefits from wages for FICA purposes. The IRS's administrative exemption is based on Rev. Rul. 56-249. To qualify for the administrative exemption, the supplemental unemployment benefits must, among other requirements, be tied to an employee's receipt of state unemployment compensation benefits, which was not the case in the Quality Stores case.

By extending this treatment to all SUB payments, Congress avoided the practical problems that might arise if the IRS later determined that SUB payments besides severance payments linked to state benefits should be exempt from withholding. The Court concluded that, considering this regulatory background, the assumption that Congress meant to exclude all SUB payments from the definition of "wages" is unsustainable. (Staff Contributor Parker Tax Publishing)

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Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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