Oct. 29, 2013 – Severance pay has become an all too familiar term for many employers and employees across the country in recent years.

Typically, a company will announce that they have plans to cut between "x and y" number of jobs as part of a company-wide restructuring over the next few months, because they face tough competition in their product line and want to position themselves for future growth.

As part of the restructuring, the company provides executive “Jones” a severance package whereby he receives a lump sum payment of $100,000 when he is separated from the company. If that severance payment is considered a “wage” for FICA (Federal Insurance Contributions Act) tax purposes, Jones will lose 7.65 percent or $7,650 in taxes and the company will have to match that amount on top of what has been paid to Jones. In other words, the government would receive $15,300 (15.3 percent) on the severance package paid to Jones as a result of FICA taxation.

However, in light of some recent court activity, both the company and Jones might receive some good news in early 2014 regarding those FICA payments.

The U.S. Supreme Court recently granted certiorari in U.S. v. Quality Stores, Inc. As a result, the Court is now ready to resolve a conflict between the Sixth and Federal Circuit Courts regarding whether severance payments paid to employees as a result of an involuntary reduction in force are “wages” subject to FICA taxation.

What is the FICA Tax?

The FICA tax is a payroll tax imposed on both employees and employers to fund Social Security and Medicare. The maximum 2014 FICA contribution by each employee is $7,254, or 6.2 percent of their wage base. For the Medicare portion of the FICA tax, each employee pays at a 1.45 percent rate with no maximum, although employees pay an additional 0.9 percent tax on wages greater than $200,000. So each party pays a minimum FICA tax of 7.65 percent (totaling 15.3 percent) on wages to the government to support Social Security and Medicare. The result of the case should have a substantial impact on both employees receiving the severance payments and employers making those payments. The government's opening brief in the case is due Nov. 15, 2013 and oral argument will likely be scheduled for early 2014.

Factual Background

The dispute occurred when Quality Stores entered the bankruptcy process and shut down its operations in 2001. Quality Stores offered certain employees two types of severance plans. One type provided severance payments based on the employee’s job grade and management level in the organization. The second type was offered to employees if they deferred their job search efforts and remained dedicated to the organization by promising severance payments if their jobs were eliminated.

After making the payments and withholding the FICA amounts, Quality Stores argued that the severance payments were Supplemental Unemployment Benefit Plan (SUB Plan) payments and sought a refund. The IRS denied the refund claim based on its long-standing position that severance payments like the ones issued by Quality Stores are wages and subject to FICA taxation. The IRS relied on this long-standing position and its prior victory in the Federal Circuit where it convinced the court that similar severance payments did not qualify as SUB Plan payments. See CSX v. United States, 518 F.3d 1328, 1344 (Fed. Cir. 2008). Despite the CSX holding, the IRS has lost at each level in the present litigation.

A Brief History

SUB Plans appeared in the 1950s. They were originally set up by employers to provide severance payments to employees on top of any unemployment compensation benefits they received from the state unemployment compensation system.

At the time SUB Plans were conceived, all dismissal-type payments from employers to separated employees were considered wages for purposes of FICA taxation. SUB Plans would not provide a benefit to former employees if the payments constituted wages because most displaced employees would then be ineligible to receive unemployment compensation benefits under their respective state laws.

In response, the IRS introduced an administrative definition that included numerous elements that would render the SUB Plan payments to be non-wages for withholding purposes. However, the IRS still mandated that SUB Plan payments would constitute gross income for federal income tax purposes.

Congress later provided that employers had to withhold federal tax withholdings (but not FICA withholdings) from SUB Plan payments and in order to be a severance payment that is exempt from FICA and Medicare coverage, it must satisfy the following five (which was less than the IRS had previously promulgated) separate elements: (1) an amount paid to an employee; (2) pursuant to an employer’s plan; (3) because of an employee’s involuntary separation from employment; (4) resulting directly from a reduction in force, the discontinuance of a plan toward operation, or other similar conditions; and (5) included in the employee’s gross income.

This statutory provision went largely unnoticed and the IRS’s definition for SUB Plan payments was used instead. As a result, employers and employees have assumed since then, based on the IRS’s strict definition, that severance payments are wages, and are therefore subject to FICA taxation. The CSX court adopted this administrative definition when determining if severance payments are SUB Plan payments exempt from FICA taxation or if they are dismissal payments which are subject to FICA taxation.

Quality Stores Distinguishes the CSX holding

Instead of following the CSX court, the Quality Stores court adopted the statutory definition over the administrative definition. After that initial interpretation issue was resolved, the Sixth Circuit Court of Appeals then relied on statutory language that “deems” SUB Plan payments to be wages for federal tax withholding purposes only.

The negative implication from that statutory language is that SUB Plan payments are not “actual” wages and, therefore, are excluded from FICA taxation – absent a legislative provision that “deems” the SUB Plan payments to be wages for FICA purposes. Billions of tax revenue is potentially at stake.

After a Decision in 2014, What Happens?

If the U.S. Supreme Court decides that severance payments are taxable for income tax purposes, but not for FICA tax purposes, thousands of employees and numerous employers would be entitled to tax refunds for tax years that are still open to the statute of limitations (3 years for individual tax filers). For the 2010 tax year, the statute of limitations runs on April 15, 2014 (unless the tax return was properly extended). Lawyers should consult clients who received severance pay over the last several years to consult a tax professional regarding prompting their former employers on the issue, to confirm whether the employer has protected its right for potential refunds.

An employer filing a protective claim for refund secures the right to a refund. Because FICA tax is a withholding tax, the employer is the only mechanism that currently exists for refunding tax that has been withheld. Taxpayers should know that refunds are unlikely to be paid – and may ultimately be denied by the IRS altogether – unless the U.S. Supreme Court rules definitively on the issue in favor of the taxpayers.

Some experts believe the IRS may act ahead of the Court and deny the protective claims upon filing. If that happens, taxpayers would have two years from the date of denial to file the appropriate refund claim in their local district court.