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Severance Payments Are Not Subject to FICA Taxes
Posted in Tax and Finance

Has your company ever made severance payments to employees who have been laid off? If so, you and your former employees may be entitled to refunds of FICA taxes on such payments.

Recently, the Sixth Circuit Court of Appeals ruled that certain severance payments (known as Supplemental Unemployment Compensation Benefits or “SUB Payments”) made by employers to laid-off employees are not subject to FICA taxes. Because many employers and employees have been paying FICA taxes on SUB payments, this recent court decision could provide an opportunity for your business to recoup past FICA taxes paid and reduce future tax bills.

What are FICA taxes?

The purpose of Federal Insurance Contributions Act (FICA) taxes is to fund the Social Security and Medicare programs. For 2012, 10.4 percent of an employee’s wages up to an annual limit ($110,100 for 2012) must be paid into Social Security, and an additional 2.9 percent must be paid into Medicare. Employers and employees each pay half of the imposed tax, although for 2012, the employee’s share of Social Security is 4.2 percent, while the employer’s share is 6.2 percent. The employee’s share of the FICA tax is paid by the employer by withholding the FICA tax payment from the employee’s paycheck. 

On which payments are FICA taxes imposed?

To answer this question simply – FICA taxes are imposed on “wages” paid to an employee. In most cases, the term “wages” has the same meaning for both income tax withholding and FICA tax purposes. Generally, wages are defined as all forms of payment for purposes of employment. For purposes of this definition, “employment” means any service performed by an employee for the person employing him.

It may be fairly obvious that an employee’s hourly pay constitutes “wages” paid for purposes of “employment,” and thus are subject to FICA taxes. But there are many other forms of payments made from an employer to an employee that fall within the definition of “wages” for purposes of FICA.

Are severance payments subject to FICA taxes?

In the recently decided case, U.S. v. Quality Stores, the Sixth Circuit Court of Appeals ruled that FICA taxes are not to be imposed on severance payments made to employees who have been laid off, as long as certain conditions are met.

Rather than being treated as “wages,” which are subject to FICA taxes, the Sixth Circuit declared that certain severance payments classified as “supplemental unemployment compensation benefits” (SUBs) were not “wages,” and were thus exempt from FICA taxes for both the employee and employer. In order for a severance payment to be classified as a SUB payment that is exempt from FICA, it must be:

a) Paid to an employee;
b) Pursuant to an employer’s plan (rather than connected to the receipt of state unemployment compensation);
c) Because of an employee’s involuntary separation from employment, whether temporary or permanent;
d) Resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions; and
e) Included in the employee’s gross income.

What does this mean for employers?

The Sixth Circuit’s recent decision gives companies which made these qualified severance payments, and the discharged employees who received them, an opportunity to claim refunds on FICA taxes paid on account of these payments. Employers and employees should also be able to avoid paying FICA taxes on such severance payments made in the future.

However, before taking advantage of the Sixth Circuit’s decision, you should note that this severance payment exemption is construed very narrowly. Severance payments can only escape the broad reach of the taxable FICA wage base if they are being paid so as to constitute SUB payments (e.g., due to involuntary layoffs by a company). Also, be aware that a 2008 decision out of the Federal Circuit Court of Appeals reached the opposite conclusion on whether the FICA tax applies to severance payments. Due to these conflicting decisions, the Internal Revenue Service may appeal the Sixth Circuit’s decision to the Supreme Court.

But until the Supreme Court ultimately rules on the issue, companies (outside the Federal Circuit) that have experienced recent layoffs and have paid FICA taxes on severance payments should look to use this taxpayer-friendly decision to apply for FICA tax refunds and to reduce their future FICA tax expenditures.

If you have questions about how this recent decision may impact you or your business, please contact a member of our Tax and Finance Practice Group.

  • Partner

    Ross D. Cohen serves as Co-Leader of the Federal Tax Team and concentrates his practice on federal tax transactional and planning issues of partnerships, joint ventures, limited liability companies and S and C corporations.

    With ...

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