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Tuesday, November 13, 2012

Circuits/IRS Split When It Comes to FICA Taxation of Severance Pay

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An issue that comes up frequently with employers is whether severance payments to employees are subject to FICA taxation (OASDI and HI taxation).   Recent Circuit cases have muddied the waters by providing conflicting conclusions.

Despite a Circuit conflict, the IRS continues to assert that all severance payments are wages subject to FICA taxation, unless they meet the narrowly-tailored definition of "supplemental unemployment benefits" under existing IRS guidance.  Such benefits are defined as payments on account of an employee's involuntary separation from employment that results directly from a reduction in force, the discontinuance of a plant or other similar conditions.  In addition, the IRS requires that such severance payments not be made as a lump sum and specifically be designed to supplement state unemployment benefits that the individual is eligible to receive. 

In a 2008 case, the Federal Circuit adopted the IRS's reasonings, exempting severance payments from FICA taxation only where they met the IRS's narrowly-tailored definition of "supplemental unemployment benefits." 

Recently, the 6th Circuit (covering Kentucky, Michigan, Ohio and Tennessee) held that severance payments are not subject to FICA taxation if they meet a less narrow definition of "supplemental unemployment benefits" than the one required by the IRS.  Specifically, severance payments are exempt from FICA taxation if they are paid to an employee: (1) pursuant to an employer's plan; (2) because of an employee's involuntary separation from employment, whether temporary or permanent; and (3) as a direct result of a reduction in force, the discontinuance of a plant or operation, or other similar condition.   Severance payments can be made in a lump sum and need not be designed to supplement state unemployment benefits.  In reaching its conclusion, the 6th Circuit expressly declined to follow the Federal Circuit's 2008 opinion, creating a split among the circuits with respect to FICA taxation of severance payments.    

Despite the 6th Circuit's ruling, most severance payments will still be subject to FICA taxation.  This is because most severance payments are made to an individual or to a small number of employees and are not made as the direct result of a reduction in force or discontinuance of a plant.  However, for those payments that meet the 6th Circuit definition of supplemental unemployment benefits (currently or as of 2009, which still remains an open period through April 15, 2013 for filing tax claims), employers may consider whether they want to file FICA tax refund claims for open years for FICA taxes paid and withheld on severance payments made to employees.  

Notwithstanding the 6th Circuit's ruling, care still should be taken when deciding whether or not to withhold FICA taxation on severance payments.  This is because the IRS continues to take its more narrow position that such payments are subject to FICA taxation.  In fact, on October 18, 2012, the government filed a petition for rehearing en banc in the 6th Circuit, asking the full court to reverse the panel decision.  

 --Shaun Terrill 

Federal Tax Law Editor (Compensation Planning)

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