Supreme Court Holds Severance Payments Are Taxable Wages

Supreme Court Holds Severance Payments Are Taxable Wages

WASHINGTON, D.C. — (Mealey’s) Severance payments fall within the definition of wages in the Federal Insurance Contributions Act (FICA) and are taxable, the U.S. Supreme Court ruled March 25 (United States of America v. Quality Stores, Inc., et al., No. 12-1408, U.S. Sup. [enhanced opinion available to subscribers. subscribers may access Supreme Court briefs for this case].

“Quality Stores contends that, under the mandate of [26 U.S. Code] §3402(o), severance payments are not subject to FICA taxation but are to be deemed wages for purposes of income-tax withholding.  It justifies this differential treatment in the name of uniformity.  But that so-called uniformity as to the definitions of wages (i.e., that severance payments are not wages) is not consistent with the broad textual definitions of wages under FICA and income-tax withholding.  Nor is it consistent with this Court’s holding that administrative reasons justify treating severance payments as taxable for both FICA and income-tax purposes.  To read Congress’ command to withhold severance payments as an implicit overruling of the broad definition of wages in FICA would disserve the statutory text and the congressional interest in administrative simplicity deemed controlling in Rowan [Cos. v. United States (452 U.S. 247 [1981]) enhanced opinion],” Justice Anthony M. Kennedy wrote for the court.   All members joined except Justice Elena Kagan, who took no part in the consideration or decision of the case. 

However, the high court noted “that severance payments tied to the receipt of state unemployment benefits are exempt not only from income-tax withholding but also from FICA taxation.” 

Retailer Shuts Down 

Quality Stores was the largest agricultural-specialty retailer in the country serving farmers, hobby gardeners, skilled trade people and do-it-yourself customers.  In October 2001, an involuntary Chapter 11 bankruptcy petition was filed against Quality Stores.  Within two weeks, Quality Stores answered the petition and consented to the entry of an order for relief.  Thereafter, Quality Stores’ affiliated companies commenced voluntary Chapter 11 bankruptcy cases.  In May 2002, the bankruptcy court confirmed the first amended joint plan of reorganization. 

Before Nov. 1, 2001, Quality Stores closed 63 stores and nine distribution centers and terminated the employment of approximately 75 employees in the corporate office.  After Nov. 1, 2001, Quality Stores closed its remaining 311 stores and three distribution centers and terminated the employment of all remaining employees. 

Quality Stores made severance payments to the terminated employees pursuant to two separate plans.  Under the terms of the Pre-Petition Severance Plan, severance pay was based on job grade and management level.  Quality Stores made the severance payments on the normal payroll schedule. 

The Post-Petition Severance Plan was designed to encourage employees to defer their job searches and dedicate their efforts and attention to the company by assuring them that they would receive severance pay if their jobs were eliminated.  To be eligible for severance pay, an employee was required to complete the last day of service as scheduled.  The post-petition severance amounts were paid in a lump sum. 

About 900 employees did not receive any severance pay because they were hired immediately by successor companies. 

Severance Taxes 

Because the severance payments constituted gross income to the employees for federal income tax purposes, Quality Stores reported the payments as wages on W-2 forms and withheld federal income tax.  Quality Stores also paid the employer’s share of FICA tax and withheld each employee’s share of FICA tax. 

While Quality Stores collected and paid the FICA tax, it did not agree with the Internal Revenue Service that the severance payments constituted wages for FICA purposes.  Quality Stores took the position that the payments made to its employees pursuant to the plans were not wages but instead constituted supplemental unemployment compensation benefits (SUB) payments that were not taxable under FICA. 

As a result, Quality Stores asked 3,100 former employees to allow the company to file FICA tax refund claims on their behalf.  Of those contacted, 1,850 former employees allowed Quality Stores to pursue FICA tax refunds for them. 

In September 2002, Quality Stores timely filed with the IRS seeking the refund of $1,000,125 in FICA tax.  This figure consisted of $571,127 for the employer share and $428,998 for the employee share attributed to those employees who granted Quality Stores consent to pursue their claims.  When the IRS did not allow or deny the refund claims, Quality Stores filed an adversary action in the U.S. Bankruptcy Court for the Western District of Michigan in June 2005. 

Ruling Appealed 

Bankruptcy Judge James D. Gregg entered a final judgment in favor of the plaintiffs after determining that the payments were not “wages” for the purposes of FICA taxation.  The United States appealed.  U.S. Judge Janet T. Neff of the Western District of Michigan affirmed the Bankruptcy Court’s decision on Feb. 23, 2010. 

The United States appealed once more.  On Sept. 7, 2012, the Sixth Circuit U.S. Court of Appeals affirmed the lower courts.  The United States then petitioned the U.S. Supreme Court. 

Oral arguments were held Jan. 14. 


Solicitor General Donald B. Verrilli Jr. and Assistant to the Solicitor General Eric J. Feigin in Washington represent the United States.  Robert S. Hertzberg of Pepper Hamilton in Southfield, Mich., represents Quality Stores. 

Professor Kristin E. Hickman of the University of Minnesota Law School in Minneapolis filed an amicus curiae brief in support of neither party. 

Allyson N. Ho of Morgan, Lewis & Bockius in Dallas filed an amicus brief on behalf of American Payroll Association.  Robert A. Long Jr. of Covington & Burling in Washington filed an amicus brief on behalf of ERISA Industry Committee. 

Patrick J. Smith of Washington filed an amicus brief on behalf of American Benefits Council.

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