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US Supreme Court Agrees Severance Pay Is Taxable, by Mike Godfrey,, Washington Monday, March 31, 2014

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 pay.

"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 taxable wages."




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