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Severance Payments and Taxes - A Dilemma Solved

Earlier this year, the U.S. Supreme Court heard arguments concerning a tax refund request that has approximately $1 million in value. At issue is whether severance payments to workers who were involuntarily terminated are taxable under the Federal Insurance Contributions Act tax, or FICA, which helps pay for Social Security and Medicare. In the case before the Supreme Court, the Obama administration and the taxpayer, Quality Stores, argued over seemingly contradictory language in the tax code related to severance pay and FICA taxes.

The Tax Code defines wages as “all remuneration for employment.” The Obama administration is suggesting that any severance payments were in fact wages and were taxable for FICA purposes. However, a different portion of the Tax Code provides that “supplemental unemployment benefits” are exempted from income taxes. Quality Stores argued that its severance payments are exempt from FICA taxes because they are unemployment benefits. Specifically, Quality Stores opined that section 3402(o) of the Tax Code, which governs supplemental unemployment compensation benefits, should be interpreted to exempt the payments at issue from FICA taxes. Such severance payments do not amount to wages, because the recipient of said payments has terminated from employment. In reference to Quality Stores’ argument, the Justices questioned the congressional purpose behind passing section 3402(o), pressing the Obama administration’s interpretation of section 3402(o), which would render it unnecessary.

As background on this case, in September 2012, the 6 th Circuit Court of Appeals ruled in Quality Stores favor, finding that severance payments were not taxable under FICA. However, in the Court decision, the judges acknowledge that the tax code language is “complex” and “the correct resolution of the issue is far from obvious.”

On March 25, 2014, The U.S. Supreme Court ruled that taxes are due for Social Security and Medicare on severance packages paid to workers who are laid off voluntarily. In a win for the Obama administration, the court voted 8-0 that Quality Stores and its employees are not entitled to tax refunds. In dismissing Quality Stores’ argument, the court stated, “severance payments are not exempted, and they squarely fall within the broad textual definition of wages for purposes of income-tax withholding.”

Needless to say, the outcome of this case has shaped the FICA tax implications of supplemental unemployment compensation benefits and may influence whether employers continue to provide termination benefits.