FICA Taxes on Severance Pay
Author: Jesse Palmer
Given the recent downturn in the economy, many employers have been forced to downsize their work force. Often, employees receive severance packages as part of the downsizing measures. While it is well known these severance payments are subject to federal income tax withholding, the payroll tax implications are not as certain. Over the past several decades, the IRS and courts have come to various conclusions on whether severance payments are subject to Federal Insurance Contributions Act (FICA) taxation. Most recently, a U.S. District Court in Michigan affirmed an earlier bankruptcy court decision that severance payments are not subject to FICA taxation. While the IRS is likely to appeal the decision, it does present potential refund opportunities for employers and employees who have paid FICA taxes on severance payments in the past few years. This article will examine the current status of this issue and what options are available to employers who have paid FICA taxes on severance payments in light of this recent decision.
The IRS position on FICA taxation of severance payments is found in a series of Revenue Rulings. In the most recent ruling (Revenue Ruling 90-72), the IRS provides a very narrow window when severance payments are not subject to FICA taxation. To qualify for FICA tax exemption, severance payments must meet the IRS definition of supplemental unemployment compensation benefits (SUB pay). SUB payments must meet several criteria, including:
- Benefits are paid only to unemployed former employees laid off by the employer
- Payments must be linked to the receipt of state unemployment compensation
- The employee’s seniority affects the duration of benefits
- The benefits are not paid based on the rendering of particular services
- The right to benefits does not accrue until a prescribed period after termination of employment
- Payments cannot be received in a lump sum
Payments that do not meet all the criteria are not considered SUB payments and are subject to FICA taxation.
The two most relevant court decisions on FICA taxation of severance payments provide different conclusions. In 2002, the U.S. Court of Federal Claims held in CSX Corporation Inc. v. United States that severance pay was not subject to FICA. For withholding purposes, the Internal Revenue Code defines SUB payments as amounts paid to an employee because of an employee’s involuntary separation from employment directly resulting from a reduction in force, the discontinuance of a plant or operation or other similar conditions. The court agreed with the taxpayer that this definition of SUB payments also applies for FICA purposes. However, in 2008, the U.S. Court of Appeals reversed this decision on the grounds that the definition of SUB payments for income tax withholding did not have to be used for FICA purposes and instead, the definition provided in IRS Revenue Rulings should apply.
On February 23, 2010, a U.S. District Court decision in United States v. Quality Stores, Inc. arrived at a different conclusion. In this case, the district court affirmed a bankruptcy court decision that severance payments made by the taxpayer were not subject to FICA taxation. It arrived at this conclusion based on the following factors:
- Severance payments are intended to serve the same purpose as Social Security benefits. They are not taxable remuneration for the employee’s services or wages.
- The conclusion that the statutory definition of SUB payments for income tax withholding purposes should not also apply for FICA purposes has no basis. Therefore, the IRS Revenue Rulings cannot override the statute’s provisions.
The area of FICA taxation of severance payments is still unsettled, and the IRS is likely to appeal the district court decision. However, this decision does provide some hope that FICA taxes paid on severance payments in open tax years may eventually be refunded. Employers who have not yet filed refund claims for FICA taxes paid on severance payments made in 2006 should consider filing protective refund claims no later than April 15, 2010. Also, employers who have had refund claims denied by the IRS as a result of the Court of Appeals decision in CSX Corporation v. United States should consider appealing the IRS’ decision or filing a refund suit.
For more information, please contact your BKD advisor.