Severance Payments Not Subject to FICA Tax

Herbein Tax Update - Recent court ruling treats some severance payments as not subject to FICA tax

Barry D. Groebel, CPA

In a recent court case (U.S. v. Quality Stores, Inc.), the court held that in certain situations supplemental unemployment benefits (SUB) or severance payments are not considered wages for Social Security and Medicare taxes (FICA tax).

Increased Layoff Activity in Recent Years
Due to increased layoff activity in recent years this case has drawn considerable attention and varying interpretations.

This court decision has gained considerable media attention since many companies have experienced layoffs and made severance payments in recent years. The ruling has been covered in several financial news publications and is the topic of newsletters and alerts from various financial consultants.

Interpretations of the potential impact of this court decision vary considerably. Some commentators are suggesting a wait and see approach since it is likely the IRS will appeal the case, while others are implying that this decision means that current severance payments are not subject to FICA tax and refund opportunities exist for prior FICA tax paid on severance payments.

Items to Consider Related to Severance Payments
It is important to note the following with respect to the Quality Stores case.

The court case was in the Sixth Circuit, which only covers Kentucky, Ohio, Michigan and Tennessee. Per the court case - a payment only qualifies as a SUB payment if it is:

  • An amount paid to an employee;
  • Pursuant to an employer’s plan;
  • Because of an employee’s involuntary separation from employment, whether temporary or permanent;
  • Resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions; and
  • Included in the employee’s gross income.

There is a conflicting Federal circuit case ruling (CSX Corp, v. U.S.) that considered SUB payments to be wages subject to FICA.

Since the Quality Stores case really only applies to states in the Sixth Circuit (Kentucky, Ohio, Michigan and Tennessee) and only to qualified SUB payments directly resulting from a reduction in force, the discontinuance of a plant or operation, or other similar conditions, it appears unlikely that it will apply to Pennsylvania employers.

In addition, it seems fairly clear that the taxayer favorable treatment in the case would not apply to a severance payment to a single or limited number of terminated employees if not related to a reduction in force or discontinuance of a plant or operation.

Therefore, we suggest that in most cases it will be prudent to continue subjecting severance payments to FICA tax and it is unlikely that refund opportunities exist for prior FICA tax assessed on severance pay.

However, if an employer makes severance payments related to massive layoffs due a reduction in force or the closing of plants or locations, it may be beneficial to consider the potential benefits of this taxpayer favorable ruling. This could include layoffs at for-profit businesses and also at non-profits such as school districts and municipalities.

Please contact Barry Groebel if you have questions regarding the FICA tax treatment of severance pay.

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Barry D. Groebel, CPA
Herbein + Company, Inc.