Yesterday, the Supreme Court gathered to decide an issue that had drawn the attention of tax advisors and subpar employees the country over: Is severance pay pursuant to an involuntary layoff subject to FICA employment taxes?
The answer was a resounding “yes,” a reversal from the rulings previously handed down by the District Court and Sixth Circuit. But before we delve into the high court’s reasoning, let’s take a look at how we got here.
SUB Payments, In General
The treatment of certain supplemental unemployment compensation benefits (“SUB”) for FICA purposes has long been clouded. SUB payments were created in the 1950s as a way to supplement the state unemployment compensation benefits received by employees upon involuntary termination, and were defined in Section 3402(o) as amounts:
1) Which are paid to an employee,
2) Pursuant to an employer’s plan;
3) Because of an employee’s involuntary separation from employment, whether temporary or permanent,
4) Resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions; and
5) Are Included in the employee’s gross income.
As you might imagine, this will encompass most involuntary severance payments.
These SUB payments have always been subject to federal income tax withholding by virtue of that same Section 3402(o), which provides that for purposes of determining whether a SUB payment is subject to withholding, it “shall be treated as if it were a payment of wages by an employee to an employee for a payroll period.” I’ve emphasized this “as if” language because as we will see, it has played a pivotal role in the case history surrounding the application of FICA taxes to SUB payments.
CSX Corporation
In the most important court decision on this issue prior to September 2012, the Court of Appeals for the Federal Circuit concluded in CSX Corporation v. United States, 518 F.3d 1328 (Ca. Fed. Cir., March 2008), that this “as if” language did not mean that SUB payments were treated as wages only for purposes of determining whether they were subject to federal income tax withholding. Rather, the court held that SUB payments were also wages for purposes of FICA taxes, stating:
…because we have rejected the first part of CSX’s argument-that the reference to the term “wages” in section 3402(o) necessarily implies that all payments falling within the definition of SUB in that subsection are non-wages, we reject CSX’s statutory argument. Based on that analysis, we disagree with the trial court’s conclusion that all payments that qualify as SUB under the statutory definition in section 3402(o)(2)(A) are non-wages for purposes of FICA.
Quality Stores
In September 2012, the Sixth Circuit took a different approach and reached a different conclusion in Quality Stores, Inc. v United States, holding that severance payments were not subject to FICA.
Quality Stores was an agricultural-specialty retailer who filed for Chapter 11 during 2001. Prior to November, 2001, Quality Stores involuntarily terminated 75 employees, with all remaining employees terminated after November 2001 when Quality Stores closed its doors and went out of existence.
As part of the severance packages offered by Quality Stores, employees were paid based on years of service, and the payments were not tied to the receipt of any state unemployment compensation. Because SUB payments clearly represent income that is subject to federal income tax withholding pursuant to Section 3402(o), Quality Stores reported the payments on the recipients’ Forms W-2, and remitted over $1,000,000 in FICA tax to the IRS. Soon after, Quality Stores filed a claim of refund for the FICA taxes, arguing that the severance payments were not subject to FICA as they were not “wages” for those purposes.
In an initial hearing, a bankruptcy court ruled in favor of Quality Stores in 2005, and in September 2012, the 6th Circuit affirmed the bankruptcy court’s decision, holding that the SUB payments were not wages subject to FICA tax.
The 6th Circuit reached its conclusion by first looking to the legislative history of Section 3402(o). When the provision was enacted in 1969, Congress recognized that SUB payments “are not subject to federal income tax withholding because they do not constitute wages or remuneration for services.” Because SUB payments represent taxable income to the recipient, however, Congress wanted to take the income tax burden off the recipient by requiring withholding at the source, adding:
Although these benefits are not wages, since they are generally taxable payments they should be subject to withholding to avoid the final tax payment problem for employees.
In addition, the Sixth Circuit agreed with the taxpayer’s argument that the chosen language of Section 3402(o) – when read in the negative – provides that severance payments are not generally considered wages. Section 3402(o) provides that for federal withholding purposes, SUB payments are to be treated “as if” they were wages; this language would be unnecessary, the taxpayer argued, if these severance payments were generally treated as wages under the statute.
Having established that SUB payments were not wages for federal income tax purposes, the Sixth Circuit then looked to prior case law, which held that Congress intended for the definition of wages for federal income tax and FICA purposes to be one and the same.[i]
The Sixth Circuit ultimately concluded that Congress imposed federal income tax withholding on SUB payments because they qualify as gross income, not because they are “wages.” Reading the definitions of “wages” found in the FICA and federal income tax statutes consistently, the court held that SUB payments do not constitute “wages” under either statutory scheme.
Supreme Court
Yesterday the Supreme Court overturned the Sixth Circuit’s decision and held that severance payments are subject to FICA taxes. The Supreme Court took a more simplistic approach than the lower courts, holding that FICA’s broad definition of wages includes severance payments.
Section 3121 defines wages as “all remuneration for employment…” The term employment encompasses “any service, of whatever nature, performed…by an employee for the person employing him.”
The court then concluded that as a matter of plain meaning, severance payments are “remuneration for employment,” for the following reasons:
They are made to employees only;
In consideration for employment;
Severance payments often vary according to the function and seniority of the terminated employee; adding weight to the opinion that the payments were made as payment for services;
Severance payments can be desirable from the perspective of an employer to reinforce its reputation as a worthy employer.
Next, the court reasoned that if standard severance payments were to be excluded from the reach of FICA taxes, the statute would provide a specific exemption, as it does for severance payments made because of retirement for disability under Section 3121(a)(13)(A). Extracting additional support from the statutory structure, the court argued that this exemption for disability-based severance payments would be unnecessary if, as the Sixth Circuit held in Quality Stores, all severance payments were excluded from FICA wages as a general rule.
Lastly, the Supreme Court dismissed the notion that the “as if” language of Section 3402(o) meant that severance payments are generally not wages for FICA purposes. Rather, the court determined that Congress wrote Section 3402(o) in the manner it did so that regardless of whatever position the IRS took in the future with respect to certain categories of severance payments being included within wages, they would all be subject to federal withholding. Under this reasoning, the fact that all severance payment would be treated “as if” they were wages did not mean that otherwise, no severance payments would be wages. Or as the court illustrated, the statement, ‘All men shall be treated as if they were six feet tall does not imply that no men are six feet tall.”
[i] See Rowan Cos. v. United States, 452 U.S. 247 (1981)