Is Severance Pay Taxable Under FICA?

Is severance pay taxable under the Federal Insurance Contributions Act, 26 U.S.C. § 3101 et seq (“FICA,” informally known as “Social Security tax”)? This is the question at the heart of the tax refund dispute that has made its way to the U.S. Supreme Court in U.S. v. Quality Stores, Inc. (12-1408).

Quality Stores was a retailer that filed for Chapter 11 bankruptcy in 2001 and later closed forever, including involuntarily terminating nearly 2,000 employees.

The company offered severance pay to terminated employees based on their positions, years of service, and salaries, and reported the payments on recipients’ W-2 forms. Quality Stores also withheld FICA taxes (both its and its employees’ shares), and remitted them to the IRS. Soon after, Quality Stores sought a refund for itself and its employees, arguing severance payments are not “wages” that can be taxed under FICA.

After the IRS declined to respond to the refund request, Quality Stores successfully litigated the issue as part of the Chapter 11 bankruptcy proceedings, and the bankruptcy court’s ruling was affirmed on appeal by the district court and, later, the Court of Appeals for the Sixth Circuit in September 2012.

While this may seem like a dreary and arcane tax dispute, the financial implications of this issue are substantial. FICA taxes are used by the federal government to fund social welfare programs such as Social Security and Medicare. If the Supreme Court affirms the Sixth Circuit, this could result in billions of dollars of tax refunds to employers and their former employees, but these refunds would be paid out of monies that would otherwise be used to fund federal social welfare programs.

Indeed, as reported by Forbes, the Sixth Circuit’s ruling in 2012 caused “a flood of protective claims for refund of payroll taxes, particularly from those employers who made severance payments to terminated employees during the recent economic downturn.”

The U.S. Supreme Court held oral argument on January 14, 2014, and a decision will hopefully be out soon. In any event, irrespective of outcome, this is a matter of statutory interpretation of the tax code, and Congress can weigh in if it disagrees with the high court’s ruling.

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