Avoiding what attorneys say could have been an “earthquake” effect from businesses rushing to file for a collective $1 billion in tax refunds, the U.S. Supreme Court recently held that severance payments are wages for federal tax withholding purposes.
The court’s decision in U.S. v. Quality Stores Inc. concluded that “supplemental unemployment compensation benefits,” or SUBs, fall within the definition of “wages” and therefore are not exempt from Federal Insurance Contributions Act withholding requirements.
The 6th U.S. Circuit Court of Appeals had held that the payments were exempt, causing the employer in the case and a number of other companies who had withheld and submitted taxes on such payments to file for refunds. But with the court’s ruling, those requests will be denied.
For most other employers, it’s business as usual.
“In my experience you always treated this kind of severance as wages,” said Daniel Moore, a partner in the Pittsford, N.Y. office of Harris Beach PLLC. “If the 6th Circuit had been upheld, the IRS would have been flooded by a lot of employers who paid FICA taxes. … The decision prevented the earthquake that would have happened if the IRS had to pay out all that money.”
Scott Roberts, co-managing partner of Hirsch Roberts Weinstein LLP in Boston, agreed.
“Generally the longstanding position of employment attorneys, whether plaintiff-side of defense attorneys, is that severance payments are subject to tax withholding,” Roberts said. “So from my perspective, the impact of this decision will not be very severe.”
The case stemmed from bankruptcy proceedings initiated by Quality Stores, a former agricultural specialty retailer.
The company, which ceased operations when it filed for bankruptcy, had issued severance payments to employees who lost their jobs, reported the payments as wages on the employees’ W-2 forms and withheld and paid FICA taxes on the payments.
In its bankruptcy filing, the company sought a refund for the taxes, claiming that SUB payments like the severance at issue are exempted from income taxes under the Internal Revenue Code. The company relied on a tax code provision which instructs that SUBs should be treated “as if” they were wages in certain circumstances, and extrapolated from that to argue that means they are generally not treated as wages.
The 6th Circuit agreed and ruled that the severance payments were not wages and therefore FICA withholding requirements did not apply.
But the Supreme Court reversed, relying on the language of FICA.
“FICA’s broad definition of wages includes the severance payments made here,” wrote Justice Anthony Kennedy for an eight-justice majority. Justice Elena Kagan took no part in the consideration of the case.
Some questions linger
Moore noted that only a subset of severance agreements qualify as SUBs, such as payments made as part of a reduction-in-force action in response to a plant closing. Because the majority of severance packages were already presumptively taxable, most employers treated all such payments that way.
It was the 6th Circuit ruling that caught many members of the employment bar off-guard, Roberts said.
“It came as quite a bit of a surprise,” Roberts said. “It created conflict in the circuits and spurred the Supreme Court to get involved. The fact that it was an 8-0 unanimous ruling suggests to me that it was not a tough call.”
The decision leaves some unanswered questions, however, including whether the exemption for a certain subset of employment severance benefits has been narrowed. IRS regulations provide a limited exception from the FICA definition of wages for certain payments made upon the involuntary termination of an employee. The exception applies only if the payments are designed to supplement state unemployment benefits and are predicated on the receipt of such benefits.
“It’s hard to tell if the IRS will continue to recognize the limited exemption that is still there, and find that [other plans] are not subject to FICA tax withholding” said Jeffrey Capwell, a partner in the Charlotte, N.C., office of McGuireWoods LLP. “It remains to be seen if the IRS will take additional action in this area to roll the exemption back.”
The IRS has wide rulemaking ability in terms of enforcing provisions of the Internal Revenue Code, but changes in the way the agency interprets SUB payments could still bring the issue back before the court again, Capwell said.Follow @dcdicta