Certain severance benefits may not be subject to taxation under the Federal
Insurance Contributions Act (FICA), according to a recent district court
decision. In United States v. Quality Stores, Inc., No. 1:09-cv-44 (W.D.
Mich. Feb. 23, 2010), a decision affirming a bankruptcy court decision, the U.S.
District Court for the Western District of Michigan highlighted the historical
uncertainty regarding whether certain severance payments made to employees are
subject to taxation under FICA. In this episode, the court held that such
payments were not subject to FICA, as they did not constitute “wages.”
In Quality Stores, the debtors (Quality Stores) operated retail
stores. Prior to declaring bankruptcy, they were forced to close approximately
63 stores and nine distribution centers, and terminated approximately 75
employees at their corporate offices. On Oct. 20, 2001, an involuntary Chapter
11 bankruptcy petition was filed against them. Quality Stores then closed their
remaining 311 stores and three distribution centers, and terminated the
The debtors made severance payments pursuant to severance plans to employees
terminated before and after the institution of the bankruptcy proceeding.
Payments were made as a result of employees’ involuntary termination that
resulted directly from a reduction in force or the discontinuance of a plant or
operation. Employees’ severance payments were included in their gross income,
Quality Stores reported the severance payments as wages on the Forms W-2 issued
to the employees, and federal income tax and the employees' share of FICA tax
were withheld from the severance payments.
Under the pre-bankruptcy severance plan, senior executives received 12 – 18
months of severance pay, and all other employees received one week of severance
pay per full year of service. Under the post-bankruptcy severance plan, officers
received 6 – 12 months of severance; full-time salaried and hourly employees
with at least two years of service received one week of severance pay for each
full year of service, up to a maximum of 10 weeks for salaried employees and
five weeks for hourly employees; and employees with fewer than two years of
service received one week of severance pay.
Severance payments were not connected to the receipt of state unemployment
compensation and were not attributable to the rendering of any particular
employment service. The employees were paid on a weekly or semi-weekly basis, in
accordance with the debtors' normal payroll period. Quality Stores then filed 15
separate refund claims with the IRS. They sought to recover $1,000,125 in
allegedly overpaid FICA taxes.
In analyzing the claims, the court noted that the case presented a
straightforward but confounding legal question: whether the severance payments
were wages subject to FICA taxation. It concluded that the payments at issue
were not wages, and thus not subject to FICA. In reaching its conclusion, the court
noted that the IRS itself, over the last 54 years, has changed its position as
to whether such payments constituted wages, concluding most recently in 1990
that they do. See Rev. Rul. 90-72.
The court reasoned that the severance payments at issue were “supplemental
unemployment compensation benefits” under 26 U.S.C. § 3402(o). In doing so, the
court disagreed with Rev. Rul. 90-72 and the reasoning of the U.S. Court of
Appeals for the Federal Circuit in CSX Corp. v. United States, 518 F3.d 1328
(Fed. Cir. 2008), which held that benefits such as those at issue in Quality
Stores were wages subject to FICA taxation. Instead, the court found that
the severance benefits at issue were a form of wage-replacement social benefits
as opposed to remuneration for the employees’ services.
As a result of the Quality Stores decision, there is an argument to be
made that certain severance benefits are not subject to FICA taxation.
Nonetheless, that position generally is not accepted. However, the court’s
decision does open the door for other courts to follow the Quality Stores
approach. Employers should therefore carefully consider whether the severance
benefits they are paying former employees are subject to FICA taxation, until
Congress or the courts have an opportunity to resolve this issue further. Until
then, taxpayers may be well-advised to follow the approach taken by Quality
Stores, which was to pay the FICA taxes, then file for a refund.