Clients frequently ask us if severance payments are subject to tax withholding. The answer is that they clearly are subject to income tax withholding, but there has always been some ambiguity about the circumstances in which they are subject to FICA tax withholding. The IRS has always taken the position that severance payments are not subject to FICA tax withholding only when the severance payments are tied to the receipt of unemployment benefits. When the issue arose in litigation, however, the Circuits were split as to whether to side with the IRS, or whether a somewhat broader FICA exception should apply in certain cases involving bankruptcies or reductions in force. During the past few years, many employers and employees filed refund claims for FICA taxes withheld on severance payments, with the hope that the Supreme Court would issue a decision in favor of the broader exception.
Last week, the U.S. Supreme Court unanimously held in United States v. Quality Stores, Inc., that the IRS position was correct, dashing the hopes of any refunds. As such, severance payments generally are subject to FICA taxes. The only exception that the Court preserved was for supplemental unemployment benefit (“SUB”) plans under Code Section 501(c)(17), where severance benefits are tied to the receipt of unemployment benefits. For example, suppose that the employer wants to continue to allow a former employee to receive base salary for period of time after severance. Also suppose that a former employee had been earning $700 a week from the employer, and the former employee now receives unemployment benefits are $300 a week. Under a SUB plan, the former employer would pay $400 a week to make the former employee whole.
The Court also noted that even the limited exception regarding unemployment benefits appeared to be inconsistent with the plain meaning of the tax statutes. As such, we would not be surprised if the IRS later reverses its own position to eliminate this exception and require FICA tax withholding on all severance payments, even when they are tied to unemployment benefits.
For now, there is no immediate action for employers to take. As we said previously, if an employer has filed claims for refunds of FICA taxes withheld on prior severance payment, the IRS almost certainly will deny those claims. Otherwise, the case serves as a reminder that employers need to be mindful of the tax and benefits issues surrounding their former employees.