In a case that’s sure to serve as a lightning rod, a district court has ruled that severance payments are not “wages” for purposes of the Social Security and Medicare taxes. These two taxes are collectively referred to as the FICA tax. (Quality Stores, Inc., DC-MI, 2/23/10)
Alert: This decision could open the door for refund claims by employers that have previously treated severance payments as wages. This has been a common occurrence the past few years.
Nevertheless, if the ruling applies to your situation, approach it with a healthy dose of caution. The IRS is hardly throwing in the towel.
Generally, wages for federal income tax purposes are also treated as wages for FICA tax purposes. But the court drew a key distinction in the new case.
Facts: Prior to declaring bankruptcy, a retail outfit was forced to close approximately 63 stores and nine distribution centers. It also fired about 75 employees at its corporate offices. After filing an involuntary Chapter 11 bankruptcy petition, the retailer closed its remaining 311 stores and three distribution centers and terminated the employment of the remaining employees.
Severance payments were made to terminated employees. The amount depended on whether they had been fired before or after the bankruptcy proceedings. These severance payments were reported as wages on the W-2 forms issued to the employees. Both federal income tax and the employees’ share of FICA tax were withheld from the severance payments.
Subsequently, the retailer filed 15 separate refund claims with the IRS. It sought to recover more than $1 million in overpaid FICA taxes.
Taxpayer victory: The district court said the severance payments should be treated as wage-replacement social benefits, not as remuneration for wages. Where severance payments are intended to provide support to workers who have lost the ability to earn wages, collecting FICA tax on these benefits makes little sense. As a result, the payments aren’t subject to FICA tax.
In light of this new case, you may initiate a protective refund claim for open tax years.
Tip: The IRS will probably appeal the decision. We will keep a close watch on new developments.