Are severance payments subject to FICA?

• Author: Sanders, Gary
• Position: Federal Insurance Contributions Act

PREVIEW

* A recent Supreme Court decision resolves a FICA tax issue on which federal circuit courts had reached opposite conclusions.

* Understanding the differences between "wages" for FICA and income tax purposes is key to proper withholding treatment.

* Employers must be aware of the Supreme Court's determination of when they must withhold FICA on severance payments.

The definition of wages for purposes of income tax withholding and for the Federal Insurance Contributions Act (FICA) has often been a point of contention. Sec. 3401 defines wages for income tax withholding, whereas Sec. 3121 defines wages for FICA. The Supreme Court concluded in Rowan Cos. that Congress intended the definition of wages to be interpreted in the same manner for FICA and Federal Unemployment Tax Act (FUTA) as for income tax withholding.(1)

Two recent appellate court decisions came to opposite conclusions on the question of whether severance payments are subject to FICA. In CSX Corp., (2) the Federal Circuit, agreeing with earlier decisions of the Third and Eighth Circuits, held that severance payments were subject to FICA; however, in 2012 in Quality Stores, Inc., (3) the Sixth Circuit held to the contrary. To resolve the split in opinions, the Supreme Court agreed to hear Quality Stores. The Supreme Court reversed the Sixth Circuit and held that severance payments to employees who were involuntarily terminated were taxable wages for FICA purposes. (4)

Statutory Confusion

The origin of the dispute over severance payments is in the income tax withholding statutes. Sec. 3401 defines wages expansively for purposes of income tax withholding.

Section 3401. Definitions. (a) Wages. For purposes of this chap-ter, (5) the term "wages" means all remuneration (other than fees paid to a public official) for services performed by an employee for his employer, including the cash value of all remuneration (including benefits) paid in any medium other than cash; ...

Sec. 3402 specifically extends the income tax withholding requirements to several items, including severance payments that qualify as supplemental unemployment benefits (SUBs), which "shall be treated as if it were a payment of wages by an employer to an employee for a payroll period.(6)

Although supplemental unemployment compensation benefits would qualify as wages under Sec. 3401, the legislative history surrounding the enactment of Sec. 3402(o) indicates that Congress did not consider them to be wages, thus necessitating the enactment of Sec. 3402(o) to make them subject to withholding.

Sec. 3121(a) contains a definition of wages for FICA that is similar to that in Sec. 3401. A number of items are specifically excluded from the FICA definition of "wages" under Sec. 3121, including annuity payments and sick pay, but the FICA statutes do not contain anything similar to Sec. 3402(o).

Rev. Ru!. 90-72 also indicates that the definition of SUBs under Sec. 3402 does not apply for FICA but only for income tax withholding. However, in this ruling, the IRS excluded from the definition of wages for FICA SUBs that are linked to the receipt of state unemployment compensation and are not received in a lump sum. In addition, between 1965 and 1974, the IRS issued a series of revenue rulings in which it stated that severance payments are wages for FICA purposes.(7)

CSX Corp.

During the 1980s, CSX, a railroad conglomerate, experienced financial difficulties and was forced to reduce the number of its employees significantly. The company adopted a variety of severance programs for its union and nonunion employees that included cash incentives to encourage employees to leave the company and to soften the financial blow of losing their jobs.

The issue before the Federal Circuit in the asx case was whether payments CSX made to employees under the various severance plans were subject to withholding and taxation under FICA and the Railroad Retirement Tax Act (RRTA). CSX's position was that payments to employees who were separated from employment or whose hours were reduced were not taxable under FICA or the RRTA because the payments were not "wages" for FICA purposes or "compensation" for RRTA purposes.(8) The government contended that all of the payments under the various plans were taxable as "wages" or "compensation" within the meaning of FICA and the RRTA, respectively. The lower court had held that some of the payments at issue were taxable and others were not.(9)

The Federal Circuit agreed with the government and concluded that all of the payments were subject to FICA. (10) The court found the taxation of "wages" for FICA purposes turned on the definition and tax treatment of SUBs and whether the definitions and rules applicable to SUB payments for federal income tax withholding purposes apply...