Stephen Ehrenberg
Stephen Ehrenberg

Taxing severance payments

The Supreme Court’s recent decision in Quality Stores resolves a controversial issue.

May 29, 2014
by Stephen J. Ehrenberg, CPA

On March 25, the U.S. Supreme Court issued a decision that puts an end to a dispute that has been fought in the lower courts and the appeals courts for over a decade. The dispute, which centers on whether severance payments are subject to Social Security and Medicare taxes, has been at the forefront for many taxpayers because of the economic downturn that forced many corporate employers to reduce workforces.


Social Security and Medicare taxes, also known as Federal Insurance Contributions Act (FICA) taxes, are imposed on employee wages primarily to fund health insurance and retirement for retired workers. For 2014, the base against which FICA taxes are computed is as follows:

  1. Social Security tax of 12.4% on wages up to $117,000; and
  2. Medicare tax of 2.9% on all wages with no limit.

FICA taxes, which are borne 50% by the employee and 50% by the employer, are remitted to the taxing authorities through payroll tax withholdings. This article does not discuss the additional 0.9% Medicare tax on wages that applies to higher-income individuals beginning in 2013 and that does not have an employer component.  

Lower court decisions

Whether FICA should be imposed on severance payments has been subject to debate for a number of years. Beginning with the 2002 decision in CSX Corp., 52 Fed. Cl. 208 (2002), the U.S. Court of Federal Claims rejected the IRS’s argument that the severance payments made to involuntarily terminated workers fell under the scope of wages as defined by Sec. 3121. As wages, the IRS claimed, these payments were subject to FICA and Railroad Retirement Tax Act (RRTA) withholding, in contrast to the taxpayer’s position that these payments were supplemental unemployment compensation that is exempt.

In 2008, this decision was overturned by the Federal Circuit Court of Appeals, which held that Rev. Rul. 90-72 governed whether FICA applied to severance payments. Rev. Rul. 90-72, in part, indicates that for severance payments to be exempt from FICA withholding, the payments “must be linked to the receipt of state unemployment compensation.” While there are other requirements to qualify these severance payments for FICA exemption under Rev. Rul. 90-72 (specifically that they must not be paid in a lump sum), the IRS seemed to be successful in narrowing the scope for exemption from these taxes.

As recently as 2012, this issue was still at the center of controversy, when the Sixth Circuit ruled against the IRS, holding that involuntary service termination payments were exempt from FICA (Quality Stores, Inc., 693 F.3d 605 (6th Cir. 2012), aff’g 424 B.R. 237 (W.D. Mich. 2010)).

Supreme Court decision

The Supreme Court’s recent decision on this hot-button issue ends the debate between taxpayers and the taxing authorities. In its unanimous 8–0 holding, the Court determined that involuntary service termination payments constituted wages under Sec. 3402 and therefore were subject to FICA (Quality Stores, Inc., 134 S. Ct. 1395 (2014), rev’g and remanding 693 F.3d 605 (6th Cir. 2013)).  

In arriving at this decision, the Supreme Court examined the definition and scope of wages. Whereas the decisions that were favorable for the taxpayers had taken a restricted view of wages, the Supreme Court broadened this definition to basically include “all remuneration for employment.” Furthermore, while the Code contains specific provisions exempting certain payments from FICA withholding, the Supreme Court explained that these provisions, specifically Sec. 3402(o), which focuses on state unemployment benefit compensation, should not be interpreted to exempt all severance payments from FICA.

What taxpayers should do

Many taxpayers filed protective refund claims with the IRS in an effort to preserve their rights to refunds of FICA taxes if this issue had ended favorably for taxpayers. Now that the Supreme Court has taken the IRS’s side and held that these payments are subject to FICA, those claims will obviously be denied. Taxpayers who filed those claims do not have to do anything. But, going forward, taxpayers making severance payments to terminated workers should be sure to subject these payments to FICA.

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Stephen J. Ehrenberg, CPA, MBT, is a tax principal in the Los Angeles office of Holthouse Carlin & Van Trigt LLP.