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United States v. Quality Stores: Severance Pay Is Taxable

By William Peacock, Esq. on March 27, 2014 | Last updated on March 21, 2019

This should've been an easy case of reading the plain text of the statute. Unfortunately, it's merely another example of why the entire tax code should be shredded and redrafted.

Quality Stores was going bankrupt. The company offered severance packages to all employees, based on seniority and service time. It withheld and paid Federal Insurance Contributions Act (FICA) taxes, then asked the IRS for the more than $1 million in payments back, arguing that severance pay was not subject to FICA taxation.

The Sixth Circuit, relying on an income tax withholding statute, held that severance payments were not FICA taxable. But the U.S. Supreme Court, in an 8-0 decision (with Justice Elena Kagan recused), felt otherwise.

RTFS (Read the Freaking Statute)

26 U.S.C. § 3121(a) states that wages are "all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash."

Severance is a benefit paid to employees. As a matter of plain text, it fits, especially since the plans here were tied to seniority, service time, etc. The Court noted severance pay is "like many other benefits employers offer employees above and beyond salary payments ... [l]ike health and retirement benefits, stock options, or merit-based bonuses," all of which are remuneration for employment.

Other parts of the statute, such as § 3121(a)(13)(A) -- which exempts from "wages" severance payments made "because of ... retirement for disability" -- give further support to the notion that severance payments are wages, because otherwise, that exemption would be superfluous.

Furthermore, the history of FICA taxation (don't get too excited!) shows Congress' intent. In 1939, Congress overruled an IRS regulation by exempting "[d]ismissal payments which the employer is not legally required to make" from the Social Security Act's definition of wages. (FICA was once a part of that chapter.) In 1950, Congress repealed that section, putting severance back in the wages category.

In short, plain text says "wages." History says "wages." So what confused the Sixth Circuit?

SUBs Confuse Us All

The FICA statute essentially taxes any remuneration paid to an employee, but a different statute, § 3402(o), dealing with income tax withholding, is captioned "Extension of withholding to certain payments other than wages," and reads: "[A]ny supplemental unemployment compensation benefit paid to an individual ... shall be treated as if it were a payment of wages by an employer to an employee for a payroll period."

"As if."

Why would those words be necessary if "supplemental unemployment compensation benefit[s]" were wages? Based on this argument, the Sixth Circuit inferred that SUBs (supplemental unemployment compensation benefits, which includes severance pay) were not wages for purposes of income tax withholding, and since FICA uses a substantially similar definition, the exemption rings true there as well.

That's a heck of a stretch, though a logical one.

The Court spent pages going through the regulatory history that made that little provision necessary, noting that the IRS's revenue rulings make certain SUBs (SUBs tied to the receipt of unemployment benefits) tax-free non-wages because some states won't pay unemployment if other taxable income is received. When that rule was put into place, those who received taxable supplementary benefits from a former employer got dinged with a huge tax bill due to the lack of withholding. Congress then made all SUBs, including the non-wage SUBs, subject to withholding, just in case. (Enjoy the refund check.)

All of that is unnecessary to the holding of the case, were it not for a few confused circuit court judges. Now, had Quality Stores' severance pay been tied to the receipt of unemployment benefits (non-wages, per the IRS regulation), this might be a different case. The Court warned the IRS that their differential treatment was on shaky ground, as it may conflict with the plain statutory text.

Fortunately for those receiving the income tax-free SUBs, that was not the case before the Court, so the battle will wait for another day -- or until we burn the tax code and start anew.

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