HR Support on Severance Payment Rights & Policies

Editor's Note: Taxation of severance pay remains unsettled.

Rena PirsosOverview: Severance pay paid to employees who are terminated from employment is subject to payroll withholding for federal income tax (FIT), Social Security and Medicare (FICA) tax and federal unemployment insurance (FUTA) tax. For income tax withholding purposes, severance pay is treated as supplemental wages, i.e., wages paid in addition to employees' regular wages. As part of a severance pay package, employers may also provide supplemental unemployment benefits (SUB).

Trends: As a result of a recent decision by the Sixth Circuit Court of Appeals, employers that have paid severance pay to terminated employees have been questioning whether they should file FICA tax refund claims with the Internal Revenue Service (IRS) and stop withholding and paying FICA taxes on severance pay. To avoid potential penalties, however, employers should continue to withhold FICA taxes from severance paid to terminated employees until this issue is resolved.

In United States v. Quality Stores, Inc., (6th Cir. Sept. 7, 2012), the appellate court affirmed the decision of both a federal district court and a bankruptcy court that payments to terminated employees because of a business's dissolution were SUB payments, which were not FICA or FUTA taxable. The court rejected an earlier Federal Circuit Court ruling (CSX Corp, Inc., v. U.S., (Fed. Cir. 2008)) which held that severance payments were subject to FICA taxes because they did not fit the IRS's administrative definition of SUB pay.

On October 18, 2012, the US Department of Justice (DOJ) filed a petition for a rehearing of the case by all of the active Sixth Circuit judges. If a rehearing is denied, or the judges issue an opinion in favor of Quality Stores, the DOJ may still ask the US Supreme Court to review the case, which will further prolong a final resolution.

Author: Rena Pirsos, JD, Legal Editor

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