By Mona Ghude, Esq., Stephen D.D. Hamilton, Esq., David Schectman, Esq., Jonathan D. Grossberg, Esq.
Drinker Biddle & Reath LLP, Philadelphia, PA
A recent decision by the Supreme Court in United States v. Quality Stores, Inc., No. 12-1408, 2014 BL 80719 (U.S. 3/25/14) (Kennedy, J.), means that, except in certain very limited circumstances, employers should continue to withhold the FICA tax on severance payments made in connection with a reduction in force or similar situations.
In Quality Stores, the Court held that severance payments made to employees who were terminated as part of a reduction in force were taxable as "wages" for purposes of the Federal Insurance Contributions Act (FICA). FICA imposes a tax on both the employer and the employee. If the severance payments in question were found not to be subject to FICA, both Quality Stores and the affected employees (who had timely filed protective refund claims) stood to receive substantial refunds.
The Supreme Court took up Quality Stores to resolve a split between the Circuits. Several Circuits had held severance payments to be "wages" for FICA purposes. In 2012, the Sixth Circuit took a contrary position with regard to supplemental unemployment benefits ("SUBs"). In re Quality Stores, Inc., 693 F.3d 605 (6th Cir. 2012).
In Quality Stores, the Supreme Court started with the statutory language. FICA (and income tax withholding) applies to "wages…with respect to employment." "Wages" are in turn defined as "remuneration for employment." The Court, citing its own 68-year-old precedent in which it had held that backpay awards for terminated employees constitute "wages" for Social Security purposes, concluded that the term "remuneration for employment" is not limited to "work actually done," but encompasses the "entire employer-employee relationship for which compensation is paid to the employee by the employer." Social Security Bd. v. Nierotko, 327 U.S. 358, 365-66 (1946). Thus, severance payments are remuneration attributable to the employer-employee relationship and should be viewed as "wages."
Next, the Court examined the language in §3402(o), the section the Sixth Circuit had relied upon to conclude that SUBs were not FICA "wages." Section 3402(o) is entitled "Extension of withholding to certain payments other than wages" and provides in pertinent part that "any supplemental unemployment compensation benefit paid to an individual, … shall be treated as if it were a payment of wages by an employer to an employee for a payroll period." The Court noted that, while some SUBs (those that were tied to receipt of state unemployment benefits) were not considered "wages" for FICA and income tax withholding purposes under IRS rulings in effect when §3402(o) was enacted, other SUBs were considered "wages," and that this section of the Internal Revenue Code (as well as its title) was not inconsistent with treating certain types of SUBs as wages while treating others as not wages. Section 3402(o) was enacted to ensure that income tax withholding would apply to all SUBs - and would not be limited just to those SUBs that were considered "wages" under the IRS rulings at the time. That did not, in the Court's view, imply that Congress had concluded that all SUBs were not "wages," it only implied that Congress had concluded that some SUBs were not "wages." The severance payments at issue in Quality Stores were not tied to the employees' receipt of state unemployment benefits and, therefore, were not of a kind that the IRS had ruled were not "wages" when §3402(o) was enacted.
Lastly, the Court noted that it had decided only the limited issue of whether SUBs not tied to the receipt of state unemployment benefits are exempt from FICA. Thus, it appears that an employer may continue to make severance payments that are exempt from FICA by carefully linking the severance payments to the employee's receipt of state unemployment compensation benefits. Rev. Rul. 90-72, 1990-2 C.B. 211, sets forth the guidelines for these types of SUB arrangements. It should be noted that both Quality Stores and Rev. Rul. 90-72 address SUBs paid in connection with reductions in force. It has always been, and continues to be, the case that severance payments made in connection with individual employee terminations are "wages" for FICA purposes.
For more information, in the Tax Management Portfolios, see Allman, 392 T.M., Withholding, Social Security and Unemployment Taxes on Compensation, and in Tax Practice Series, see ¶5440, Employment Tax Withholding Requirements.
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