For example, the question “Are severance payments subject to FICA taxes?” ought to have a simple “Yes” or “No” answer. Unfortunately, as two recent court decisions illustrate, the answer is unclear. But, as is often the case, this very uncertainty can provide the possibility of saving money for taxpayers.

The Tax Code imposes a tax on “wages” to fund both Social Security and Medicare. (Both employers and employees are subject to the tax.) It has long been clear that certain “supplemental unemployment benefits” (“SUB”) payments are not “wages” for FICA purposes. To qualify as a SUB, the payment must (1) follow the involuntary separation of the employee; (2) supplement state unemployment benefits; (3) not be made in a lump sum; (4) be based on the employee’s seniority and not on the rendering of any services; and (5) provide that no employee has any interest in the fund paying the benefits until the employee is eligible to receive benefits. The IRS takes the position that payments that do not meet these requirements—including most severance payments—are wages and thus subject to FICA taxation.

In February, 2010, however, a U.S. District Court in United States v. Quality Stores held that severance payments that were not SUBs were nevertheless not wages for FICA tax purposes. The payments in that case were made to employees under the company’s severance plans; the severance resulted directly from a reduction in force or discontinuing a line of business, were not connected to the receipt of state unemployment compensation, were not based on providing any employment service, and some of the payments were made in a lump sum. The court concluded that the payments were not subject to FICA taxes.

The decision in Quality Stores is directly contrary to a 2008 decision of the U.S. Court of Appeals for the Federal Circuit in CSX Corporation v. United States. In that case, the court held that severance payments not qualified as SUBs were wages and thus subject to FICA taxes.

The government views CSX as controlling and has filed an appeal in Quality Stores. Nevertheless, some taxpayers have filed refund claims to ensure that they retain their right to a refund should the Quality Stores decision ultimately be upheld. While the IRS is currently disallowing these claims, taxpayers who have made severance payments during taxable years open under the applicable statute of limitations should seriously consider filing refund claims to protect their (and their consenting employees’) rights.

This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties.

Written by Bob Gordon

Bob Gordon spent 20 years performing various domestic and international in-house tax counsel roles at BP America (formerly Amoco Corporation). He ended his career at BP at the end of 2009 as Assistant General Tax Counsel and Head of Tax for the company’s U.S.-based manufacturing and retail division. He is currently in solo practice, where he focuses on providing tax advice and counsel for small and medium-sized businesses . Bob is an active member of the American Bar Association Tax Section, where he is an Officer of the Corporate Tax Committee and served as Chair of the Energy and Environmental Taxes Committee. He is also a member of the Illinois State and Chicago Bar Associations, as well as a former active member of Tax Executives Institute (Chicago Chapter). Bob received his A.B. degree (with Honors) from the University of Illinois at Chicago in 1974 and his J.D. from Northwestern University School of Law in 1983, where he served on the Editorial Board of the Northwestern University Law Review. He is licensed to practice law in Illinois.