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A Better Partnership


Dec 2012
December 04, 2012

Sixth Circuit Holds Severance Payments Are Not Taxable FICA Wages

Employers that made severance payments after 2008 as part of an involuntary reduction in their workforce might want to consider filing a claim for refund on the taxes paid and withheld under the Federal Insurance Contributions Act (FICA). (The FICA tax funds the Social Security and Medicare programs.) Earlier this fall, in U.S. v. Quality Stores, Inc., the Sixth Circuit held that severance payments that meet the Internal Revenue Code (Code) definition of supplemental unemployment compensation benefits (SUB) payments are not taxable as wages under FICA.


In connection with a bankruptcy reorganization, Quality Stores closed all of its stores and distribution centers and terminated all of its employees. Quality Stores made severance payments to those whose employment was involuntarily terminated. Because the severance payments were gross income to the employees for federal income tax purposes, Quality Stores reported the payments as wages and withheld income tax. Quality Stores also withheld each employee’s share of FICA tax and paid the employer’s share.

Although Quality Stores collected and paid the FICA tax, it did not agree with the Internal Revenue Service (IRS) that the severance payments were wages for FICA purposes. Quality Stores took the position that the payments made to its employees were not wages but instead were SUB payments not taxable under FICA.


Definition of SUB Payments: The court looked to the Code and corresponding IRS regulations for the definition of SUB payments.

A SUB payment is defined as:
  1. an amount paid to an employee;
  2. pursuant to an employer’s plan;
  3. because of an employee’s involuntaryseparation from employment, whether temporary or permanent;
  4. resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions; 
  5. included in the employee’s gross income.

The court determined that all the payments Quality Stores made to its former employees satisfied this five-part statutory test and qualified as SUB payments.   
Taxable FICA Wages: The court noted that neither the FICA statute nor regulations address whether SUB payments are taxable FICA wages. Therefore, the court looked elsewhere to determine Congress’s intent and found it in the Code’s rules for federal income tax withholding.  Those rules provide SUB payments are subject to withholding as “other than wages.” The court concluded that even though SUB payments are subject to federal income tax withholding, they are not wages for that purpose.

The court then looked to a prior U.S. Supreme Court decision that concluded Congress intended the term “wages” to have the same meaning for both federal income tax withholding and FICA purposes. Although Congress later amended the Social Security Act to allow the IRS to issue regulations to provide for different exclusions from wages under FICA than under the income tax laws, the IRS has never issued any. Accordingly, the Sixth Circuit concluded that the statutory exemption from the definition of wages for SUB payments must be deemed extended to FICA taxes as well, until the IRS changes the rule by regulation.


The Sixth Circuit concluded that the payments Quality Stores made to its employees qualify as SUB payments. Because SUB payments are not wages for federal income tax withholding purposes, even though they are subject to withholding, they are not wages for FICA taxation.


This decision gives employers and their former employees who paid FICA taxes on severance payments made pursuant to an involuntary reduction in the workforce a potential claim for refund.  Although the Treasury and IRS likely will continue to deny refund claims for SUB payments and are expected to continue to litigate this matter, the final resolution may take several years.

All employers, not just those in the Sixth Circuit (Michigan, Ohio, Kentucky and Tennessee), should consider filing refund claims for open years for both the employer and employee portions of FICA taxes paid on severance payments that satisfy the Code’s definition of a SUB payment. This filing will preserve the right to recover FICA taxes if U.S. v. Quality Stores, Inc. is ultimately upheld. These claims generally must be filed within three years of filing IRS Form 941. The statute of limitations for filing a claim for SUB payments made during 2009 ends on April 15, 2013.

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