Friday, April 4, 2014

United States vs. Quality Stores, Inc.

On March 25, 2014, the Supreme Court of the United States ruled in United States v. Quality Stores, Inc., No. 12-1408, that severance payments, which were made pursuant to plans that did not tie payments to receipt of state unemployment benefits, are taxable under the Federal Insurance Contributions Act (FICA) when made to employees whose employment is involuntarily terminated. The Court reasoned that the definition of wages for FICA purposes encompasses severance payments and that the severance at issue in this case was not exempt from FICA tax. 

Background

Quality Stores, Inc., a specialty retailer, discharged a large number of employees in 2001 during bankruptcy proceedings and paid these employees severance payments according to a company severance plan.  Quality Stores reported the severance payments as wages on W–2 tax forms, paid any required FICA taxes, and also withheld from employees’ severance payments the required FICA taxes. The company later asked those former employees to allow it to file FICA tax refund claims for them.  Quality Stores filed a FICA-tax refund claim on behalf of the former employees and itself, which the Internal Revenue Service (IRS) neither allowed nor denied, and then initiated proceedings in the Bankruptcy Court seeking a refund of the amount of taxes paid.  The Court granted judgment in the company’s favor.  On appeal, both the Federal District Court and the Sixth Circuit Court of Appeals ruled in favor of Quality Stores.  The Sixth Circuit held that the severance payments were not subject to FICA taxes because they qualified as supplemental unemployment benefits compensation (SUB) as defined by Internal Revenue Code (IRC) section 3402(o)(2)(A).  The Supreme Court agreed to hear the case to decide whether severance payments made to involuntarily-terminated employees are FICA-taxable.

Considerations

In its March 25 ruling, the Supreme Court noted that FICA’s definition of wages includes the severance payments Quality Stores made to its employees.  Under both FICA’s definition of “wages” and the plain meaning of the terms, severance payments are wages.  Further, the Court noted that the fact that FICA exempts some termination-related payments from the definition of wages shows that the severance payments at issue were purposely not exempted.
Quality Stores’ argument and the Sixth Circuit’s decision were incorrect, the Supreme Court ruled, in using IRC section 3402(o) to conclude that severance payments are not included in the definition of wages for the purposes of income tax withholding and thus, are not included in the definition of wages for FICA taxation purposes.  Because IRC section 3402(o) covers more than just severance payments that were excluded from income-tax withholding, the Sixth Circuit’s and Quality Stores’ broad interpretation of the section failed.  The Court therefore concluded that IRC section 3402(o) “does not narrow the term ‘wages’ under FICA to exempt all severance payments” from FICA tax.

The Court also noted that the severance payments at issue in the case were not linked to the receipt of state unemployment benefits.  Based on these considerations, the Court reversed the decision of the Sixth Circuit and held that the severance payments which had been made to involuntarily discharged employees, varied based on job grade and seniority, and had not been linked to the receipt of state unemployment benefits, constituted taxable wages.

Impact on Employers

Employers across the United States utilizing a SUB plan linking separation benefit pay to the receipt of state unemployment benefits, in accordance with IRS SUB Plan guidelines, will be unaffected by this ruling, as the Supreme Court left the IRS rulings intact.  Separation pay made under a SUB plan to involuntarily separated employees that is: 1) not paid in a lump sum; and 2) linked to the receipt of state unemployment benefits, remains FICA-exempt.

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