Final answer? Severance payments can be taxed

The U.S. Supreme Court has issued the final word on the taxation of severance payments.

In a unanimous decision, the Supreme Court – reversing the 6th Circuit Court of Appeals – has held that severance payments made to involuntarily terminated employees and not tied to the receipt of state unemployment insurance are subject to tax under the Federal Insurance Contributions Act (FICA).

Quality Stores sought a refund of approximately $1 million. According to the government’s petition, the total dollar amount at stake (including other pending refund claims and litigation) was more than $1 billion. Many news outlets and industry insiders speculated that estimate was conservative.

Quality Stores entered bankruptcy proceedings in 2001. Quality made payments to employees who were terminated before and after the bankruptcy petition was filed.

The payments were made under severance plans and because of the employees’ involuntary separation from employment, which resulted directly from a reduction in force or the discontinuance of a plant or operation. The payments were not connected to the receipt of state unemployment compensation and were not attributable to the rendering of any particular employment service.

In 2002, Quality filed refund claims with the IRS for overpaid FICA, plus interest, on the severance payments. The claims included the employer’s share of FICA and the employees’ share of FICA for those employees who consented to permit Quality to make the refund request for them.

When the IRS did not allow or deny the refund claims, Quality filed an adversary action in the bankruptcy court. That court concluded that the severance payments were not wages for FICA purposes. A federal district court and the 6th Circuit Court of Appeals affirmed that decision.

However, other appeals courts have held to the contrary, including courts of appeal for the 7th, 8th and Federal Circuits. The Supreme Court, resolving the circuit split, held that severance payments fall within FICA’s definition of wages (U.S. v. Quality Stores, Inc., Sup. Ct., March 25, 2014).