On March 25, 2014, in United States v. Quality Stores, Inc. (found in full here), the Supreme Court held that severance payments, made to involuntarily terminated employees, are subject to the FICA tax. This ruling clarifies an issue which had previously been unclear due to contradicting case law.
The confusion surrounding this issue stems from the Sixth Circuit’s ruling in Quality Stores which overturned CSX Corp. v. U.S.; the result of this decision was that, according to the Sixth Circuit, severance payments were no longer considered “wages” and were not subject to FICA taxes. In response to the Sixth Circuit’s ruling in Quality Stores, many employers, believing they had been wrongly required to pay FICA taxes on severance pay, began filing protective claims in an attempt to have their FICA tax payments refunded.
The process of filing a protective claim, which must be filed within three years of a tax payment, allows an employer to file an amended tax return requesting a refund for a previously paid tax due to a change in the IRS’ stance concerning the tax in question. The filing of a protective claim for a FICA refund requires an employer to provide a Form 941-X, which is an adjusted quarterly tax return claiming the refund; a Form 8275 disclosure statement; and a cover letter explaining why the protective claim is being filed. In light of the Sixth Circuit’s ruling, many employers went through this process believing they were almost certain to receive a refund of previously paid FICA taxes.
By granting certiorari in Quality Stores, the Supreme Court provided final clarification on this issue. Unfortunately for employers, the Court overruled the Sixth Circuit, making it clear that severance payments are considered wages and thus are subject to FICA taxes. Additionally, this ruling means any FICA refund claims filed by employers will be denied and no FICA tax refunds will be forthcoming.
While this is bad news for employers, FICA taxes on unemployment benefits can still be avoided through the implementation of a supplemental unemployment compensation benefits plan (“SUB”), which are allowed by the IRS under section 501(c)(17) of the Internal Revenue Code. SUB plans function as a trust, the funding of which is linked to state unemployment benefits; due to this, an employer only has to contribute the difference between the employee’s wages at the time of termination and the amount provided to the employee by state unemployment benefits. In order for a plan to qualify as a SUB plan, it must (1) be a valid trust under local law; (2) be established and maintained by an employer solely for the purpose of providing supplemental unemployment benefits; (3) provide that the income of the trust cannot be used for any purpose other than providing unemployment benefits; (4) ensure that all benefits are determined according to objective standards; and (5) not discriminate in favor of highly compensated employees.
Although the implementation of a SUB plan can be onerous on an employer, by permitting these plans to remain exempt from FICA taxes, the Supreme Court provided employers with an alternative to avoid the payment of these taxes. In addition to the savings, for both employers and employees, from the FICA tax exemption, SUB plans allow employers to save money by relying on the state to contribute a portion of an employee’s unemployment benefits, reducing the amount to be contributed by the employer. In light of Windsor, employers should be cognizant of the Court’s clarification on severance pay and FICA taxes, and the opportunity provided by SUB plans, when reviewing or implementing unemployment benefits procedures.