Supreme Court Decides Quality Stores: Severance Pay Is Subject to FICA Taxes

Author: Rena Pirsos, XpertHR Legal Editor

March 26, 2014

Yesterday, the US Supreme Court unanimously ruled in United States v. Quality Stores, Inc., No. 12-1408 (U.S. Sup. Ct., 3-25-14), that severance payments made to involuntarily terminated employees that do not qualify as supplemental unemployment benefits (SUBs) under the Internal Revenue Code (IRC) are subject to Social Security and Medicare (FICA) taxes. The decision overturns a lower court ruling that could have required the Internal Revenue Service (IRS) to issue more than $1 billion in refunds.

The IRS treats severance pay as subject to employer withholding for federal income tax, 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 SUBs.

Quality Stores Severance Payments

Quality Stores made severance payments to employees who were involuntarily terminated. The payments, which varied based on job seniority and time served, were made according to plans that did not tie the payments to the receipt of state unemployment insurance. Quality Stores paid and withheld FICA taxes from the payments but later believed that they were SUBs and should not have been taxed as FICA wages. The now-defunct retailer then sought a tax refund of about $1 million from the IRS on behalf of itself and about 1,850 former employees. When the IRS neither allowed nor denied the refund, Quality Stores initiated bankruptcy proceedings.

In September 2012, the 6th Circuit Court of Appeals affirmed the decision of both a federal district court and bankruptcy court that the payments were SUB payments, which were not taxable under FICA or FUTA. On October 18, 2012, the US Department of Justice (DOJ) filed a petition for a rehearing of the case before all of the active 6th Circuit judges. The 6th Circuit denied the petition on January 4, 2013. However, the DOJ filed a petition with the Supreme Court, which agreed to hear the case and has now resolved the issue.

The Supreme Court Decision

Writing for the Court, Justice Anthony Kennedy concluded the severance payments were taxable wages. He reasoned that they "were made to employees terminated against their will, were varied based on job seniority and time served, and were not linked to the receipt of state unemployment benefits." Accordingly, under "FICA's broad definition of wages" as "all remuneration for employment", Kennedy concluded that the severance payments clearly fit into this definition because they are "a form of remuneration made only to employees in consideration for employment."

In rejecting Quality Stores' argument that the severance payments at issue were actually supplemental unemployment compensation that is exempt from FICA, Kennedy said this argument is not consistent with the broad textual definitions of wages under FICA and income tax withholding." In addition, Kennedy rejected Quality Stores' reasoning as not "consistent with this Court's [earlier] holding [in Rowan] that administrative reasons justify treating severance payments as taxable for both FICA and income tax purposes."