On Tuesday, March 25, 2014, the U.S. Supreme Court, in an 8-0 decision, ruled that severance payments made to employees who are involuntarily terminated are taxable wages under the Federal Insurance Contributions Act (FICA).  Quality Stores, Inc., et al., 12-1408.  The Court reversed the Sixth Circuit Court of Appeals ruling in favor of Quality Stores, which was seeking a $1 million tax refund based on its argument that severance payments were not covered by FICA and were excluded from taxation based on the Internal Revenue Code.  The Court’s ruling resolved a split between the Sixth Circuit and the Federal Circuit, and ended a legal battle with more than $1 billion at stake in potential tax refunds to employers involved in 11 separate cases with more than 2,400 refund claims.

Quality argued that its severance payments to terminated employees were actually supplemental unemployment compensation benefits (SUB), which are not considered “wages” under the Internal Revenue Code.  According to the company, “a SUB payment is a type of payment that—although made by an employer to [its] former employee—nonetheless does not meet the statutory definition of ‘wages’ because it is not remuneration for services.”  The Court noted that the severance payments were made only to employees and were based on employment-driven criteria including the position held, the employee’s length of service with the company and salary at the time of termination.  Relying on the “broad definition of wages under FICA,” the Court ruled that severance payments to employees who are terminated involuntarily are taxable under FICA.

However, in its decision the Court noted IRS revenue rulings that severance payments tied to the receipt of unemployment compensation benefits “are exempt not only from income tax withholding but also FICA taxation.”  Thus, employers appear to continue to be able to make severance payments that are exempt from income tax withholding and FICA through a carefully crafted structure linking the severance payments to the employee’s receipt of unemployment compensation benefits.

If you have any questions about the impact of this decision, please contact Alejandra Lara, or any other member of the Labor & Employment Group.

Source: Client Alert