​Recent Supreme Court Decision Will Affect Withholding on Severance Payments

March 26, 2014

The Supreme Court yesterday handed down its long-awaited decision in United States v. Quality Stores, Inc., U.S., No. 12-1408, 3/25/14, holding that severance payments made to employees terminated against their will are taxable wages subject to the Federal Insurance Contributions Act (FICA). The decision will have a dramatic impact on many employers who are engaging in downsizing or layoffs, as the decision makes clear that most severance payments made in connection with such workforce reductions are subject to the FICA.

Significantly, the Court did not rule that the FICA applied to all severance payments. The Internal Revenue Service (IRS) still provides that severance payments tied to the receipt of state unemployment benefits are exempt from both income tax withholding and FICA taxation. These severance payments were not at issue in the case. The Court explicitly stated that it was not addressing the issue of whether current IRS rulings exempting such payments from income tax and FICA withholding were inconsistent with the broad definition of wages under FICA. Accordingly, for now, employers can continue to rely on the IRS rulings to avoid withholding on payments covered by the rulings.

The Issue before the Court

At issue in the case were severance payments made by Quality Stores and its affiliates ("Quality Stores") to employees who were involuntarily terminated as part of a Chapter 11 bankruptcy. The severance payments varied based on job seniority and time served and were made pursuant to plans that did not tie payments to the receipt of state unemployment benefits. Quality Stores had initially withheld FICA taxes on the payments, but later filed a claim for refund on behalf of itself and its employees on the grounds that the severance payments were not wages subject to FICA tax. The IRS neither allowed nor denied the claim. Quality Stores initiated a proceeding in the Bankruptcy Court seeking a refund of the disputed amount. The Bankruptcy Court granted summary judgment in its favor. The District Court and Court of Appeals for the Sixth Circuit affirmed, concluding that severance payments are not "wages" under the FICA. In reaching its decision, the Sixth Circuit relied not on the FICA's definition of wages but on Section 3402(o) of the Internal Revenue Code, a provision governing income-tax withholding. Section 3402(o), which is entitled "Extension of Withholding to Certain Payments Other than Wages," specifically states that supplemental unemployment benefits (SUBs), a type of severance payment, should be treated "as if they were wages." The Sixth Circuit's decision created a conflict with prior decisions of other Courts of Appeals, which had held that at least some severance payments were subject to FICA tax.

The Supreme Court's Decision

The Supreme Court first addressed the issue of whether severance payments are "wages" for purposes of the FICA, holding that they are. The Court observed that the FICA broadly defines "wages" as all remuneration for employment. As a matter of plain meaning, therefore, severance payments fit this definition because they are a form of remuneration made only to employees in consideration for employment. For purposes of the FICA, "employment" is any service performed by an employee for an employer. By varying according to a terminated employee's function and seniority, the severance payments at issue confirmed the principle that "service" means not only work actually done, but the entire employer-employee relationship for which compensation is paid. The Court observed that this broad definition was reinforced by the specificity of the FICA's lengthy list of exemptions. The Court also noted that in 1950, Congress had repealed a specific statutory provision exempting severance payments from FICA withholding and that since that time, FICA has had no general exception for severance payments.

The Court specifically rejected Quality Stores' argument that Section 3402(o) limited the definition of wages to exclude severance payments. Quality Stores had argued that Section 3402(o)'s instruction that SUBs be treated "as if " they were wages for purposes of income-tax withholding was an indirect means of stating that the definition of "wages" for income-tax withholding did not cover severance payments. Quality Stores also contended that if the definition of wages for purposes of income-tax withholding did not encompass severance payments, then severance payments were not covered by the FICA's similar definition of wages. The Court found that severance payments are not exempted, and that they squarely fall within the broad textual definition of wages for purposes of both income-tax withholding and FICA.

Quality Stores also argued that severance payments must fall outside the definition of wages for income-tax withholding; otherwise, Section 3402(o) would be superfluous. The Court disposed of this argument by explaining that Section 3402(o)'s command that all severance payments be treated "as if" they were wages for income-tax withholding was in all respects consistent with the proposition that at least some severance payments are wages.

Quality Stores also contended that the heading of Section 3402(o), which reads, "Extension of Withholding to Certain Payments Other than Wages," effectively declares that the payments enumerated within Section 3402(o) are not wages. While recognizing that captions can be a useful aid in resolving a statutory text's ambiguity, the Court found that the heading merely stated that withholding was extended to certain payments and therefore fell short of a declaration that severance payments were not wages.

The Court analyzed Section 3402(o) in terms of the regulatory background against which it was enacted. In the 1950s and 1960s, many employers had created SUBs to provide benefits for terminated employees. A problem arose with treating such amounts as wages, however, because the laws of some, but not all, states provided that state unemployment benefits were available only to terminated employees not earning wages. Because the goal of SUBs was to provide greater economic security for terminated workers, the fact that workers in some states receiving SUB benefits would have been ineligible for state unemployment benefits if SUB payments were wages rendered SUBs much less useful. To ameliorate this problem, the IRS issued a series of Revenue Rulings in the 1950s and 1960s that took the position that SUB payments were not "wages" for purposes of FICA or income-tax withholding.

Although the Revenue Rulings eliminated the issue of whether terminated employees receiving SUB payments would be eligible for state unemployment benefits, it led to a further problem. Although SUB payments were exempt from withholding, they were still taxable income to the employee. Because no withholding was being made, terminated employees could end up with a large year-end tax liability.

According to the Court, Congress enacted Section 3402(o) to address the prospect that terminated employees would owe large payments in taxes at the end of the year as a result of the IRS's exemption of certain SUBs from withholding, rather than to define what payments were or were not wages. Congress determined that, whatever position the IRS took with respect to certain categories of severance payments as wages, the problem with withholding should be solved by treating all severance payments as if they were wages requiring withholding. Given this limited purpose, Section 3402(o) does not narrow the term "wages" under the FICA to exempt all severance payments. The Court also noted that this reasoning was consistent with the principle it had announced in Rowan Cos. v. United States, 452 U.S. 247 (1981), that simplicity of administration and consistency of statutory interpretation instruct that the meaning of "wages" should be, in general, the same for income-tax withholding and for FICA calculations.

Status of IRS Revenue Rulings on Severance Payments in Light of Court's Decision

This left the issue of the status of the IRS's prior rulings exempting certain types of severance payments from withholding. The Court noted that the IRS still provides that severance payments tied to the receipt of state unemployment benefits are exempt not only from income tax withholding, but from FICA taxation. See, e.g., Rev. Rul. 90–72, 1990–2 C.B. 211. The Court took pains in its decision to clearly state that those Revenue Rulings were not at issue in the case. Therefore, the Court did not reach the question of whether the exemption from withholding created by the IRS's rulings was consistent with the broad definition of wages under the FICA. Accordingly, for now, employers can continue to rely on the rulings to avoid withholding on the payments described in the rulings. However, the Court's ruling is broad enough to effectively subject all other severance payments (that do not qualify for any other exemption under the FICA) to FICA tax.

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