Analysis of and reflections on recent cases and rulings.

• Author: Beavers, James A.
• Position: Tax rulings

Employment Taxes

Severance Payments Subject to FICA Withholding The Supreme Court, reversing a decision of the Sixth Circuit, held that severance payments to terminated employees are subject to FICA withholding.

Background

Quality Stores was a large agricultural-specialty retailer, serving farmers, hobby gardeners, skilled trade persons, and do-it-yourself customers. In October 2001, the company filed for Chapter 11 bankruptcy. As a result of the bankruptcy, the company discontinued operations and eventually terminated all its employees. The employees received severance payments under either a prebank-ruptcy or a post-bankruptcy termination plan. Neither plan tied the severance payments to the receipt of state unemployment compensation benefits. The amount of the severance payments made under the plans varied based on the employees' job grade, management level, and length of service with the company.

Quality Stores reported the severance payments as wages on Forms W-2, paid the employer's required share of FICA taxes, and withheld employees' share of FICA taxes. It later asked 3,100 former employees to allow it to file FICA tax refund claims for them. The company filed refund claims on behalf of the former employees who agreed and on its own behalf. The IRS neither allowed nor denied the claim.

Quality Stores then filed a refund suit in bankruptcy court. The bankruptcy court found that the severance payments were not wages under FICA. The district court and the Sixth Circuit affirmed the bankruptcy court's decision. The IRS appealed to the Supreme Court, which, because of a split in the circuits on the issue, agreed to hear the case.

The Sixth Circuit's Decision

The Sixth Circuit found that the severance payments under the plans were supplemental unemployment benefits (SUBs) as defined in Sec. 3402(o), Extension of Withholding to Certain Payments Other Than Wages. Because the payments were covered by Sec. 3402(o), the court found that they were not wages for income tax purposes for two reasons. First, the title of Sec. 3402(o) referred to payments "other than wages," and the court inferred that this meant that Congress knew in enacting the statute that it was extending withholding to payments that were not wages. Second, the court cited several passages from the Senate report for the bill that included Sec. 3402(o), which directly stated that SUBs were not wages.

Finding that payments were not wages for purposes of federal income tax withholding, the court determined that supplemental unemployment compensation benefits also were not wages for FICA, based on the Supreme Court's decision in Rowan Cos., 452 U.S. 247 (1981). In Rowan, the Court concluded that because Congress defined wages almost identically for purposes of FICA and income tax withholding, it intended to coordinate the two statutory schemes "to promote simplicity and ease of administration."

The Supreme Court's Decision

The Supreme Court reversed the Sixth Circuit, holding that the severance payments made by Quality Stores under the plans were wages subject to FICA taxation. The Court found that the Sixth Circuit erred in basing its decision on Sec. 3402(o) instead of the FICA definition of wages in Sec. 3121(a). The Court concluded that severance payments fall under the broad definition of wages in FICA and that Sec. 3402(o), which Congress enacted to solve a narrow problem with income tax withholding, did not alter the FICA definition. In addition, the Court found that holding that the payments were exempt from FICA taxation but subject to income tax withholding would be contrary to its holding in Rowan.

The Supreme Court first examined whether the term "wages" for FICA purposes encompasses severance payments. Under Sec. 3121, wages include "all remuneration for employment," and employment is "any service, of whatever nature, performed ... by an employee for the...