U.S. Supreme Court Rules Most Severance Payments Are FICA Taxable
On March 25, 2014, the United States’ Supreme Court held severance payments to an employee involuntarily terminated and that was not linked to a plan which conditioned the payments to the former employee’s receipt of state unemployment benefits, are taxable under the Federal Insurance Contributions Act (“FICA”). United States v. Quality Stores, Inc., No. 12-1408.
In Quality Stores, the employer had closed several establishments and discharged thousands of employees. The employer provided the discharged employees severance payments pursuant to the terms of two termination plans, which established different severance amounts based on seniority, job grade, and management level (among other factors). Quality Stores paid its share of FICA (social security) taxes and withheld the employees’ FICA contribution from the severance benefit. The employer subsequently filed FICA tax refund claims for itself and on behalf of the former employees with the Internal Revenue Service (IRS) for an amount in excess of $1 million dollars.
When the IRS failed to address the employer’s request, Quality Stores initiated a refund proceeding in the bankruptcy court, which granted judgment in its favor. On appeal, both the federal district court and the Sixth Circuit Court of Appeals ruled in favor of Quality Stores. The Sixth Circuit held the severance payments should not be treated as “wages” subject to FICA taxes because they qualified as exempt supplemental unemployment compensation benefits (“SUBs”) as defined by Internal Revenue Code. The Supreme Court disagreed and reversed.
The Court commenced its analysis by indicating FICA defines “wages” broadly as “all remuneration for employment.” Secondly, the Court held that as a matter of plain statutory meaning, severance payments fit this definition. Third, the Court noted that since 1946, it had had interpreted the term “wages” under FICA applied to compensation in wrongful discharge claims. Fourth, the Court found the broad definition of the term “wages” under FICA, reinforced by the specificity of the statute’s lengthy list of exemptions, a list which does not include severance payments, supports including severance payment under the term “wages.” Finally, the Court recognized the IRS had ruled since 1936 the statutory definition of “wages” included “dismissal pay” for FICA purposes.
In passing, the Court also emphasized the severance payments in this case were not SUBs tied to an employer plan which conditioned severance benefit entitlement to the former employee’s concurrent receipt of unemployment benefits under state law. The Court recognized that since the 1950’s the IRS has held severance benefits paid under such SUB plans are not “wages” under FICA and the agency has not yet overturned such rulings.
This decision entails several consequences for Puerto Rico. First, the Quality Stores specific holding and analysis invalidates the Puerto Rico’s Supreme Court decision which held discharge compensation under Puerto Rico’s Wrongful Discharge Act is not subject to FICA taxation. See, Alvira v. SK & F Laboratories, 142 D.P.R. 803 (1997)(referring to Law No. 80 of May 30, 1976, as amended).
Secondly, considering the IRS still exempts SUBs from FICA taxation, employers may wish to consider redesigning their severance plans. Instead of the typical “lump sum” severance payment, some employers may move to establishing severance plans integrated with the receipt of unemployment benefits.
Employers interested in adopting SUB type severance programs need to carefully review the IRS multiple requisites for SUBs exemption, as well as potential ERISA notification and administrative obligations.
O’Neill & Borges, LLC is available for further guidance.
Finally, if the FICA exemption for supplemental unemployment compensation benefits is coupled with Puerto Rico’s income tax exemption for severance payments granted in the context of workforce reductions, reorganizations, total or partial closing of operations covered by Puerto Rico Law No. 278 of August 15, 2008, a well-designed severance program may maximize the former employee’s income.
SUB plans also have the potential of reducing the former employer’s total payout, since the severance/supplemental unemployment compensation benefits terminate if the employee is reemployed or otherwise stops receiving unemployment benefits.