On March 25, 2014, in United States v. Quality Stores, the Supreme Court held that severance payments to employees who are involuntarily terminated are taxable as wages for purposes of Social Security and Medicare taxation under the Federal Insurance Contributions Act (FICA).
In the 18-page opinion authored by Justice Kennedy, eight justices sided unanimously with the government (Justice Kagan did not participate in the case). In reaching its conclusion that no general exception exists for severance payments from the definition of “wages,” the Court looked to the plain meaning of the FICA statute, which defines “wages” as “all remuneration for employment,” the statute’s legislative history and regulatory background, as well as the recognized principle from a prior Court holding (Rowan Cos. v. United States) that the simplicity of administration and consistency of statutory interpretation instruct that the meaning of “wages” should generally be the same for income tax withholding and FICA calculations. “Severance payments are like many other benefits employers offer to employees above and beyond salary payments,” Justice Kennedy wrote. “Like health and retirement benefits, stock options, or merit-based bonuses, a competitive severance payment package can help attract talented employees.” Quality Stores’ severance payments to former employees varied in amount based on job seniority and time served, further confirming the principle that severance payments are paid in “consideration of employment.”
The Court’s opinion in United States v. Quality Stores reverses the Sixth Circuit’s prior affirmation of a Bankruptcy Court holding that the severance payments at issue did not constitute “wages” for purposes of taxation under FICA. We previously discussed the Sixth Circuit opinion, including the factual background of Quality Stores, in a January 2013 client memorandum.
In its opinion, the Court noted that under current IRS rules, severance payments tied to the receipt of state unemployment benefits are exempt not only from income tax withholding but also from FICA taxation. In the case under consideration, Quality Stores’ severance payments were not linked to receipt of state unemployment benefits. Accordingly, the Court expressly declined to address whether the IRS’s current exemption from FICA taxation for severance payments tied to the receipt of state unemployment benefits is consistent with the broad definition of “wages” under FICA. The Court also noted that certain severance payments, such as severance payments made because of retirement for disability, are specifically exempt from FICA taxation under the statute.
The Supreme Court’s decision may leave open some room to structure severance tied to state unemployment benefits to take advantage of the current IRS treatment for those arrangements. Please feel free to reach out to any of your Davis Polk contacts to discuss this further.