On March 25, 2014, the United States Supreme Court ruled in favor of the Internal
Revenue Service (IRS), in deciding that involuntary severance payments made by companies
to laid-off employees are subject to federal payroll tax.
With thousands of refund claims and cases worth a combined total of more than
USD1bn currently before the IRS, the Supreme Court had recognized the importance
of an issue that had received mixed decisions in lower courts. The question
had been uncertain for some years, but was raised again more recently because
there were substantial lay-offs of personnel during the recession from 2007
onwards, and many taxpayers were expecting refunds if the IRS had failed in
the Supreme Court.
The test case, United States v. Quality Stores, Inc., et al (No. 12-1408),
involved the payroll tax under the Federal Insurance Contributions Act (FICA), which helps to fund Social Security retirement pensions and Medicare health
insurance for the elderly and disabled.
Quality Stores was declared bankrupt in 2001, laid off its workers and granted
them severance pay, on which it paid and withheld payroll tax. The following
year, however, the company claimed a tax refund from the IRS of more than USD1m,
divided between the payroll tax paid by the company and the amounts it had withheld
from the terminated employees' severance pay.
It was been argued on behalf of the company that severance pay was not to be
considered a "wage" and should not therefore be subject to tax under
FICA. While it is provided, as a "general rule," that "any supplemental
unemployment compensation benefit paid to an individual … shall be treated
as if it were a payment of wages," the term "supplemental unemployment
compensation benefit" is then defined to include "amounts which are
paid to an employee … because of an employee's involuntary separation
from employment … but only to the extent such benefits are includible
in the employee's gross income."
Quality Stores contended that, while the severance payments it made represented
supplemental unemployment compensation, they were not included in gross income
for tax purposes, and that the payments were not made for employment but rather
for the elimination of employment.
On the other hand, the IRS contended the opposite view, that severance pay,
like any other wage, is taxable for FICA purposes. It argued that FICA's broad
definition of wages encompasses an award of back pay because such a payment
is based on, and made on account of, "the entire employer-employee relationship."
For example, the amounts of the severance payments depended on particular employees'
level of seniority, length of service with the company, and regular rate of
"The severance payments were made to employees terminated against their
will, were varied based on job seniority and time served, and were not linked
to the receipt of state unemployment benefits," the Supreme Court judgment
said. "Under FICA's broad definition, these severance payments constitute