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Is Severance Pay Subject to FICA?

After conflicting decisions in the lower courts, the Supreme Court will soon decide whether workforce-reduction-severance payments are considered wages that should be subject to Federal Insurance Contributions Act taxes. Regardless of that outcome, though, experts advise employers take a proactive approach on the issue.

Wednesday, January 8, 2014
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HR professionals will want to pay close attention when the Supreme Court decides whether severance payments made in connection with a workforce reduction or businesses closing constitute "wages" subject to Federal Insurance Contributions Act or FICA tax.

"There's about $1 billion – maybe more – in refunds at stake if the court finds that SUB payments are not subject to FICA tax," says Brian O'Laughlin, senior manager of government relations and multinational certification of the Washington-based American Payroll Association.

In the case of United States v. Quality Stores, Inc., the U.S. Court of Appeals for the 6th Circuit ruled in September 2012 that downsizing payments made to involuntarily terminated employees are not wages, and therefore not subject to FICA taxes. However, the decision made in the 6th Circuit conflicted with an earlier Internal Revenue Service ruling on the payroll tax treatment of supplemental unemployment compensation benefits, aka SUB payments. On Jan. 14, the Supreme Court will hear United States v. Quality Stores, Inc., but it will likely be months later when the public learns of its verdict.

A leading advocate for payroll professionals, the APA filed an amicus brief with the court on behalf of its 22,000 members. "We don't believe SUB payments are subject to FICA tax," says O'Laughlin. "The court's decision will affect our members directly."

O'Laughlin recalls the facts of the case, which involve a garden center that went bankrupt and laid off thousands of employees, who subsequently received SUB payments. In 2002, Quality Stores claimed an IRS refund for more than $1 million in FICA taxes. If the Supreme Court decides in favor of Quality Stores, the decision will affect the many companies that made SUB payments to laid-off workers in the past few years.

"We're advising employers to file protective-refund claims," O'Laughlin says, noting that filing the claim now will hold open the door in the event that SUB payments are not taxable for FICA purposes.

Sheryl Jaffee Halpern, an attorney at Chicago-based law firm Much Shelist, agrees, but cautions HR leaders that time is of the essence.

"The Supreme Court likely won't make a decision until after the April 15, 2014, IRS filing deadline, so employers would be wise to file protective refund claims as soon as possible," she says. "If you've had a workforce reduction in the past two years and paid FICA taxes, it's a good idea, but don't delay."

In addition, employers should be poised to act as soon as the Supreme Court decision is rendered, says Russ Hall, an executive compensation expert in Towers Watson's research and innovation team in White Plains, N.Y.

"Make sure you consider this new exemption and incorporate it in a reduction program, but you will have to qualify under the relatively modest rules the 6th Circuit would impose," he says, noting that under current IRS standards, just qualifying for the exemption could impose a significant administrative burden on employers.

Hall likens it to the employers' obligation to monitor the extent to which an employee is eligible for unemployment benefits. "They can't discern if an [ex-]employee has another job, but the IRS standard is that they have to do just that, which puts them in a bind. But, if the court rules in [their] favor, and that condition does not apply, employers should take a hard look at utilizing this exemption during any time of workforce reduction."  He adds that employers should consult with legal counsel before making a decision.

Hall also recounts that, in 1969, the Internal Revenue Code was amended to apply income-tax withholding to SUB payments, even though they are not otherwise considered wages for withholding purposes.

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"SUB payments are taxable income, like any severance pay," he says, "but Congress was afraid people wouldn't understand that, if it were not subject to withholding, [it] could leave taxpayers facing huge tax liabilities at the end of the year."

He says that, while the tax code requires income-tax withholding on SUB amounts, "this infers that SUB payments would not be considered wages for income tax withholding purposes were it not for this statutory provision."

And experts say the recusal of Justice Elena Kagan opens the door for the possibility of a 4-4 deadlock.

"There hasn't been a lot of guidance on how SUB payments are subject to FICA, which is why it's going to the Supreme Court," notes Hall, adding that a split decision at the Supreme Court level might prompt Congress to step in and clarify things.

Jeffrey Davine, tax attorney in the Los Angeles office of Mitchell Silberberg and Knupp, says the limited window for filing a claim will soon be closing.

"If you've had layoffs, this case could be important; especially in respect to the 2010 tax year," he says, noting that refunds can be requested until the later of three years after the FICA tax return is filed or two years after the tax has been paid. Employers that obtain consent from former employees could also file a claim for a refund on their behalf, he says.

Davine also advises HR to go back and gather a list of people who were laid off and provided with severance benefits.

"You will certainly need it to file a claim for a refund," he says. "You will have to prove to the IRS with substantiation that the payments you made fall within the confines of the Quality Stores case."

Davine acknowledges that, while it may cost some time and money for an organization to file a claim, "if you're talking about a few hundred or thousand employees laid off, it will be worth it."

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