Are supplemental unemployment benefits paid to laid-off employees considered “wages” under the Federal Insurance Contributions Act (FICA), and therefore taxable as income?
In 2001, Quality Stores made severance payments to employees who were involuntarily terminated after Quality Stores filed for Chapter 11 bankruptcy. Quality Stores later argued that the payments should not have been taxed as wages under the Federal Insurance Contributions Act (FICA). When the IRS did not respond to Quality Stores’ claim seeking a $1 million refund in FICA taxes, Quality Stores commenced an adversary action in bankruptcy court. The bankruptcy court ruled for Quality Stores, concluding that the severance payments were non-taxable supplemental unemployment benefits (SUBs). The district court and Sixth Circuit affirmed. The Supreme Court will determine whether severance payments to involuntarily terminated employees are taxable wages under FICA. The Court will resolve a circuit split between the Sixth and Federal Circuits in a decision that will affect all employers who provide severance pay. At stake are billions of dollars in FICA tax refunds to employers and their former employees.
Questions as Framed for the Court by the Parties
Whether severance payments made to employees whose employment was involuntarily terminated are taxable under the Federal Insurance Contributions Act (“FICA”), 26 U.S.C. 3101 et seq.
In October 2001, involuntary Chapter 11 bankruptcy proceedings commenced against Quality Stores, the largest agriculture-specialty retailer in the United States at the time. See In re Quality Stores, Inc., et al., 693 F.3d 605, 608 (6th Cir. 2012). With bankruptcy proceedings underway, Quality Stores closed all of its stores and distribution centers and terminated all of its employees. See id.
Quality Stores offered severance payments to many employees who were involuntarily terminated. See id. These payments were unrelated to the employees’ ability to claim state unemployment compensation and were paid in a lump sum. See id.at 609. Nearly one thousand employees received no payments because they had immediately found employment with successor companies. See id.While Quality Stores promptly filed appropriate tax forms and ultimately paid over $1 million in Federal Insurance Contributions Act (FICA) taxes, it believed that the severance payments should not be taxed as wages. See id. Instead, Quality Stores argued that these payments were supplemental unemployment benefits (SUB) payments and not taxable under FICA. See id.
In September 2002, Quality Stores requested a refund from the IRS of approximately $1 million in FICA taxes. See id. The IRS did not respond to the request, and Quality Stores, in June 2005, commenced an adversary action in bankruptcy court. See id.The bankruptcy court found that the payments were SUBs, and ordered a refund to Quality Stores. See id. at 607–08. The U.S. District Court for the Western District of Michigan affirmed the decision of the bankruptcy court. See id. at 608. The United States appealed to the Court of Appeals for the Sixth Circuit, which unanimously affirmed the district court’s holding. See id.The Supreme Court granted certiorari on October 1, 2013 to determine whether severance payments to involuntarily terminated employees are taxable wages under FICA.
Quality Stores argues that severance payments to involuntarily laid off employees are not “wages” subject to FICA taxes. The United States argues that severance payments fall under Congress’s broad definition of “wage” under FICA, and are used to fund important social welfare programs like Medicare and Social Security. According to the government, severance payments must meet certain criteria in the IRS Rulings to be exempt from taxation for FICA purposes.
SOCIAL WELFARE PROGRAMS VERSUS THE NEED FOR UNIFORMITY
The United States argues that to fund programs like Medicare and Social Security, FICA requires taxes on all wages paid by employers or received by employees. See Brief of Petitioner at 10. These programs exist, the United States emphasizes, to provide benefits to retired and disabled workers and their families. Id. at 2. In the government’s view, FICA uses sweeping language to define “wages” and “employment” such that severance payments to involuntarily terminated employees fall within those definitions. See id. at 10. Just because the recipient of the severance payment is no longer employed, the United States argues, the payment does not lose its status as a kind of wage. See id. at 13. According to the government, consistent with prior IRS rulings, a severance payment is exempt from FICA tax only if it is linked to the receipt of state unemployment compensation, which is not the case here. See id. at 17-18.
The ERISA Industry Committee (ERIC), in support of Quality Stores, argues that the taxable status of SUB payments must be uniform across all states. See Brief of the ERISA Industry Committee in Support of Respondents at 29-30. According to ERIC, if the federal tax status of SUB payments is tied to an employee’s state of residence, then employees from the same company can be subject to different federal tax liability. See id. at 29-30. This disuniformity results, ERIC argues, because every state has developed different unemployment benefits for its workers; accordingly, following the government’s position will burden employers and ultimately result in inconsistent results across the states. See id. at 29.According to ERIC, relying on the text of the federal statutory provisions in determining whether SUB payments are taxable wages under FICA creates a uniform rule that will not result in different treatment among similarly situated employees receiving SUB payments. See id. at 30.
UNDUE HARDSHIPS ON EMPLOYEES
ERIC further argues that the government’s position will block individuals who are not eligible for state unemployment benefits from receiving the benefit of non-wage treatment of SUB payments. See Brief of ERIC at 30-31. As such, ERIC contends that individuals who are not eligible for state unemployment benefits and thus face additional hardships, will be further burdened. See id. at 31. In fact, ERIC claims that the historical reason for not treating SUB payments as “wages” for federal tax purposes was to benefit recipients, not to reduce the value of these benefits. See id. at 31. ERIC further argues that the government’s position harms employees because the IRS treats lump sum SUB payments made as taxable “wages” under FICA. See id. at 33. ERIC claims that lump sum payments are a crucial part of state benefits as they allow employees to deal with expenses resulting from the sudden loss of employment and delay from receiving state benefits. See id.at 33.
The United States stresses that employees who pay FICA taxes on “wages” generally accrue corresponding wage credits. See Brief of United States at 2. Accordingly, the United States argues that these employees receive additional FICA-financed benefits. See id. For this reason, the United States maintains, Congress defined “wages” broadly as encompassing all remuneration for employment to ensure a large FICA tax base. See id. at 3. Here, the government argues that the severance payments were a “final reward” for the recipients’ service as employees.Id. at 8.
In this case, the Supreme Court will determine whether severance payments to involuntarily terminated employees are subject to taxation under FICA. The United States argues that the SUB payments fall within the definition of “wages” in the statute, and supports its case by citing the statutory language, the legislative history, and prior caselaw. The United States therefore urges a broad reading of the term “wages” for FICA purposes. In addition, the United States urges that language from the definition of wages for income tax purposes supports its interpretation.
Quality Stores replies that the plain language of the statute does not support the interpretation that SUB payments are wages for FICA purposes. In addition, Quality Stores argues that the legislative history and the Supreme Court’s precedents support its more narrow reading of the term. Finally, Quality Stores argues that, despite the similarity in language, the definition of wages for income tax purposes should have no bearing on the term’s meaning under FICA.
ARE SEVERaNCE PAYMENTS PAID TO FORMER EMPLOYEES “WAGES”?
The United States argues that the supplemental unemployment benefit payments at issue in this case fall under the definition of “wages” and are therefore taxable under FICA. See Brief for Petitioner at 10. According to the United States, the severance payments provided by Quality Stores to its terminated employees fall under the broad language of FICA, which defines wages as “all remuneration for employment.” See id. The United States argues that all severance payments fall under this expansive understanding of “wages,” as the payments are directly tied to the work employees performed for the company. See id. at 12. According to the United States, the fact that severance payments were based on the type of work an employee performed for the company, with distinctions made between salaried and hourly employees, supports the contention that the payments made by Quality Stores should be considered remuneration for employment, and therefore wages. See id. at 19. Further, the United States points to explicit exceptions to FICA’s definition of “wages” as evidence that these severance payments are wages. See id. at 15. The United States notes that FICA contains clear exceptions to its definition of wages, including, for example, certain kinds of disability payments. See id. at 14–15. As severance payments are not included in these explicit exceptions, the United States argues they should be considered wages under FICA’s definitions. See id. at 14.
Quality Stores counters that these payments are supplemental unemployment benefit (SUB) payments and not wages. Quality Stores points to the plain language of the Internal Revenue Code, focusing on the provision that wages are payments for services provided to the employer. See Brief for Respondents at 17. Quality Stores argues that because SUB payments are not for services performed but, instead, occur after the employee-employer relationship has terminated, they do not fall under the clear definition of wages. See id.
The United States also argues that Supreme Court precedent supports its position that SUBs fall under the definition of “wages.” The United States points to two previous cases, Social Security Board v. Neirotko and Otte v. United States, where the Supreme Court has held that payments paid after the employee-employer relationship had ended were considered wages. See Brief for Petitioner at 11, 13. According to the United States, these precedents make clear that wages can derive from payments incurred after the termination of the employer-employee relationship, so the severance payments provided to former Quality Store employees are also wages. See id. at 12–13.
Quality Stores contends that Supreme Court precedents support its position that SUBs are not wages. Quality Stores points to Coffy v. Republic Steel Corp., where the Court held that SUB payments “cannot be compensation for work performed,” as supporting their position that the payments in question in the present case are not wages. See Brief for Respondents at 33–34. Quality Stores also argues that the United States misreads Court precedents regarding what type of payments fall under the definition of wages. See id. at 35–39. According to Quality Stores, the cases the United States cites actually deal with back pay and payment for services performed during employment, not with an employer-employee relationship that has already been terminated. See id.
Finally, the United States argues that the legislative history of FICA supports its position. In 1939, Congress passed an amendment that removed certain types of dismissal payments from the definition of “wages,” but Congress repealed this amendment in 1950. See Brief for Petitioner at 16. Thus, according to the United States, because Congress consciously rescinded its exception of dismissal payments from the statutory definition of “wages,” Congress intended severance payments in this case, which constitute a form of dismissal payment, to be considered wages. See id. at 17.
Quality Stores responds that the legislative history definitely proves that SUB payments are not wages, citing a Senate Committee report that unambiguously states that SUBs are not subject to FICA withholding because they are not wages or remuneration for services. See Brief for Respondents at 25.
IS 26 U.S.C. § 3402(o) APPLICABLE TO FICA’S DEFINITION OF “WAGES”?
The United States argues that the definition of wages for purposes of the income tax in 26 U.S.C. § 3402(o) is inapplicable to FICA, and, therefore, that this statute is irrelevant to the case at hand. See Brief for Petitioner at 22–23. According to the United States, § 3402(o) establishes a rule for income tax withholding and therefore should not be used to narrow FICA’s broad definition of “wages.” See id. at 21. Instead of considering the definition included within § 3402(o), the Court should solely rely on the definition of “wages” in the language of FICA. See id. at 23.
The United States argues that § 3402(o) was intended to resolve the issue that some SUB payments were considered income but not defined as wages, and consequently were not withheld, leaving the taxpayer with a significant payment due at the end of year. See id. at 32–33. The United States points out that § 3402(o) requires that all SUB payments be treated as wages for the purpose of income tax. See id.It does not follow, according to the United States, that just because some severance payments would not otherwise be considered wages that no severance payments should be considered wages. See id. at 27–28. Finally, the United States argues that if Congress had intended § 3402(o) to narrow FICA’s definition of wages, it would have done so explicitly in the FICA statute itself. See id. at 24, 36. To amend FICA’s definition of wages through § 3402(o), according to the United States, would be a very indirect means for Congress. See id. at 23.
Quality Stores counters that § 3402(o) does apply to this case because the definition of “wages” is the same for FICA and income tax purposes. See Brief for Respondents at 39–40. Quality Stores contends that the United States’ position that § 3402(o) is overinclusive and therefore not relevant to FICA is flawed for several reasons. See id. at 20–24. First, Quality Stores maintains that the United States’ position has no grounding in the language of the statutes. See id. at 20. According to Quality Stores, there is no evidence that the statutory language treating SUB payments “as if they were a payment of wages” indicates that SUBs were not actually wages. See id. at 22. Further, Quality Stores argues that § 3402(o) makes no distinction between SUBs that may or may not be wages, as the statute does for sick pay, for example. See id.According to Quality Stores, the Court should take Congress’s language at face value and not attempt to read in an erroneous distinction between SUB payments that are and are not “wages.” See id. at 24. Finally, Quality Stores argues that the United States’ reading § 3402(o) renders the statute superfluous as applied to SUB payments. See id. at 23.
In this case, the Supreme Court will determine whether severance payments to terminated employees are taxable wages under FICA. The Court will resolve a circuit split between the Sixth and Federal Circuits in a decision that will affect all employers who provide severance pay. At stake are billions of dollars in FICA tax refunds to employers and their former employees. Accordingly, the Court’s decision will directly impact the size of the FICA tax base, which helps fund two landmark social programs, Social Security and Medicare.
- Laura Saunders, Can Severance Pay Be Taxed?, The Wall Street Journal, (Nov. 8, 2013).
- Robert Sherry, Severance Payment Tax Treatment to Get Supreme Court Review, Thomson Reuters, (Oct. 9, 2013).
- Global Tax Alert, US Supreme Court Agrees to Hear Quality Stores Case on Whether Severance is Subject to FICA, Ernst & Young, (Oct. 2, 2013).