Involuntary severance benefits not subject to FICA tax.

• Author: Ely, Mark H.

Severance pay is generally considered compensation for services rendered and as such, wages subject to income tax and FICA tax withholding. The IRS has clearly stated this position in Regs. Sec. 31.3401(a)-1 (b)(4), which states, "any payments made by an employer to an employee on account of dismissal, that is, involuntary separation from the service of the employer, constitute wages regardless of whether the employer is legally bound by contract, statute, or otherwise to make such payments," as well as in Rev. Rul. 75-44, for FICA taxes.

However, in CSX Corp., 4/1/02, the Court of Federal Claims concluded that certain severance payments were not subject to FICA taxes. While the definition of wages in Sec. 3121 for FICA tax purposes usually mirrors the definition of wages for income tax withholding purposes in Sec. 3401, only under Sec. 3402(o) are "supplemental unemployment compensation benefits" subject to income tax withholding; no similar specific exception exists for Sec. 3121 purposes. Therefore, the court concluded, "supplemental unemployment compensation benefits" are not subject to FICA taxes.

Note: The CSX decision occurred just two weeks prior to the close of the statute of limitations for all four quarters of 1998 employment tax returns, which caused taxpayers to file a flurry of protective claims with the IRS by April 15, 2002. Whether employers will do the work necessary to perfect those claims will depend on the future of the CSX decision.

Under Sec. 3402(o), an employer must withhold income taxes from "supplemental unemployment compensation benefits" Such benefits are:

[A]mounts which are paid to an employee, pursuant to a plan to which the employer is a party, because of an employee's involuntary separation from employment (whether or not such separation is temporary), resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions, but only to the extent such benefits are includible in the employee's gross income.

Traditionally, the Service has sought to restrict the types of payments considered supplemental unemployment compensation benefits. In Rev. Rul. 90-72, it ruled that such benefits must be linked to the receipt of state unemployment compensation and must not be received as a lump-sum to be excluded from the definition of wages for FICA purposes.

However, in CSX, the Court of Federal Claims took a much broader view of the term. Between 1984 and 1990, CSX reduced...