The tax implications of resolving employment-related disputes can be tricky to navigate, even for a seasoned practitioner. (For more information on the tax consequences, see Tax Considerations When Settling Employment Cases, Reminger Report, Oct. 28, 2014.) The Supreme Court provided a recent reminder of how convoluted tax laws can cause confusion, this time in the context of severance pay.
In United States v. Quality Stores, Inc., 134 S. Ct. 1395 (2014), the Supreme Court explained that severance payments made to employees terminated against their will are taxable wages under the Federal Insurance Contributions Act (FICA), 26 U.S.C. § 3101 et seq. As such, severance payments are subject to FICA payroll withholdings, and employers must pay FICA taxes accordingly.
The case arose from a massive layoff orchestrated by Quality Stores, Inc., an agricultural-specialty retailer. The company was forced to lay off thousands of employees, many of whom received severance payments based on title, length of service, and willingness to continue working for a specified period of time after the company filed for Chapter 11 bankruptcy in 2001. The company reported the severance payments as wages, paying the employer’s portion of FICA taxes and withholding the employees’ share. Later, Quality Stores applied for a refund under the theory that FICA taxes are not owed on severance pay.
After working its way through the judicial system, the Supreme Court reversed the Sixth Circuit Court of Appeals. The Sixth Circuit (which reviews cases venued in Michigan, Ohio, Kentucky, and Tennessee) found that the severance payments were not taxable wages under FICA. See In re Quality Stores, Inc., 693 F. 3d 605 (2012). The Sixth Circuit’s decision created a circuit split: the Third, Eighth, and Federal Circuits had concluded that at least some severance payments do constitute wages subject to FICA tax. The Sixth Circuit also opened the door to tax refunds for employers who paid FICA taxes on severance payments in the past. The Supreme Court was quick to foreclose that possibility.
After reviewing the language of relevant statutes, the Supreme Court qualified severance pay as “wages” for purposes of FICA taxation. The Court found that this was a reasoned and commonsensical approach given the statutory scheme and congressional intent. As a result, employers, when offering remuneration to employees in conjunction with termination, should report severance payments as wages, pay the employer’s portion of FICA taxes, and withhold the employee’s share.
The Quality Stores case illustrates the tax challenges posed in the employment context and the significant financial impact that tax treatment can have, especially for mass layoffs. But even in isolated situations where a single employee is offered a severance package, employers (especially those previously adhering to the Sixth Circuit’s now-abdicated decision) must be careful to withhold and pay FICA taxes. Failure to do so may result in long-term headaches, including stiff fines and penalties.
To avoid tax-related pitfalls when offering severance pay, employers must understand tax ramifications. Not unlike settlement agreements, a severance package should specify the type and tax treatment of remuneration offered. This is important not only to avoid inconsistent tax reporting,[1] but also to avoid irritating already dissatisfied employees who may have believed they were due to receive a larger net payout. Because severance payments are often used to avoid potential conflicts upon termination, there is little use in creating unnecessary rifts with former employees based on tax treatment. Simply put, employers should be cognizant of tax implications when issuing payments to employees, whether in the context of standard payroll, settlement payments, or severance payments.
If you would like a full copy of the Quality Stores opinion, or have any other questions regarding employment matters, please contact one of our Employment Practice Liability Group Members.
[1] Note: it is important to consult with a tax professional to ensure proper tax reporting.
This has been prepared for informational purposes only. It does not contain legal advice or legal opinion and should not be relied upon for individual situations. Nothing herein creates an attorney-client relationship between the Reader and Reminger. The information in this document is subject to change and the Reader should not rely on the statements in this document without first consulting legal counsel.
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