In U.S. v. Quality Stores, Inc., No. 12-1408, (U.S. 3/25/14), the Supreme Court determined that payments made to employees pursuant to an involuntary termination would be subject to Federal Insurance Contributions Act (FICA) taxes.

Quality Stores, as a result of an involuntary Chapter 11 bankruptcy, made severance payments to employees whose employment was involuntarily terminated. Under an initial severance arrangement, the level of severance payments was based on such factors as job grade and management level. Under a second plan, the payments were used to entice employees to defer a job search by providing that they would receive payments if their job was eliminated. Under neither plan were payments tied to state unemployment benefits. Further, employees were not required to prove they were unemployed to receive payments under either plan.

Because the severance payments constituted gross income to the employees for federal income tax purposes, Quality Stores reported the payments as wages on Forms W-2 and withheld federal income tax. Quality Stores also paid the employer’s share of the Federal Insurance Contributions Act (FICA) tax and withheld each employee’s share of the FICA tax on severance-package payments issued.

Although Quality Stores collected and paid the FICA tax, it did not agree with the IRS that the severance payments constituted wages for FICA purposes. Quality Stores took the position that the payments made to its employees pursuant to the plans were not wages but, instead, constituted supplemental unemployment compensation benefits (SUB) payments that were not taxable under FICA.

Lower courts were previously divided on the issue. However, when the case eventually ended up in the Sixth Circuit court of appeals, the Sixth Circuit allowed Quality Stores to obtain a refund of the FICA taxes paid, agreeing with the district court that the payments Quality Stores made to its employees pursuant to the severance plans qualify as SUB payments. The IRS, disagreeing with this decision and arguing that FICA taxes must be withheld, sought review from the Supreme Court.

In its March 25, 2014 decision, the Supreme Court reversed the Sixth Circuit, stating that the payments constituted wages subject to FICA taxes because the payments were compensation for services and not related to SUB payments. In its analysis, the Court stated that FICA defines “wages” as “all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash.” The Court reasoned that severance payments are remuneration for employment and that FICA includes multiple exemptions for certain termination-related payments, which in the Court’s view, reinforced the idea that severance payments were within the definition of wages. The Court further disagreed with Quality Stores’ contention that language found in IRC § 3402(o) would somehow narrow the definition of wages under FICA and required remittance of all tax on severance-package payments issued to the terminated employees.

The Court did note, however, that the IRS still provides that payments tied to the receipt of state unemployment benefits are exempt not only from income tax withholding but also from FICA taxation.

In its conclusion, the Court stated that the payments were made to employees terminated against their will, were varied based on job seniority and time saved , and were not linked to the receipt of SUB payments. As a result, the Court ruled in favor of collecting FICA tax on severance-package payments.

The refund, if allowed, would have gone to Quality Stores and 1,850 former employees who paid the taxes and authorized Quality Stores to recoup the payments on their behalf.

The full text of the Supreme Court decision may be found here.