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Severance pay: Is it FICA taxable or not?

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in Office Management,Payroll Management

A federal appeals court has ruled that a bankrupt company’s severance payments qualified as FICA-free supplemental unemployment benefits—also known as SUB pay. Therefore, the court concluded, the company’s $1 million FICA refund claim was proper.

Warning: This severance pay plan is typical of most severance pay plans, which means that the IRS is facing potentially hefty refund claims submitted by other employers. As a result, it’s unlikely that the IRS will take this decision lying down. (U.S. v. Quality Stores, Inc., No. 10-1563, 6th Cir., 2012)

SUB pay

SUB pay isn’t wages, but it is taxable. In the 1950s, the IRS issued rulings in which it concluded that SUB pay that was tied to employees’ receiving unemployment benefits wasn’t payroll-taxable. Even so, tax code Section 3402(o) requires employers to withhold income taxes from SUB pay, as if it were wages. SUB pay isn’t FICA taxable if, among other requirements, it’s paid out of a trust, tied to the receipt of unemployment benefits and isn’t paid in a lump sum.

The million-dollar question

The company paid severance under two severance pay plans. Employees received severance based on job grade, management level and years of service. Under the first plan, em­­ployees received severance pay on their normal paydays. Under the second, employees received lump-sum payments. In neither case were employees required to collect unemployment benefits.

The company withheld FICA taxes from the payments. Later, claiming that the severance qualified as SUB pay, it filed a $1,000,125 refund claim, which the IRS denied. Three courts then brushed aside the IRS’ requirements for SUB pay and ruled in the company’s favor—a bankruptcy court, a federal trial court and a federal appeals court.

Under the appellate court’s interpretation, almost any severance pay plan would qualify as SUB pay. Court: The payments are made to employees, under a plan, because of their involuntary separation from employment, resulting directly from a reduction in force or similar condition and are included in employees’ gross income. Since SUB pay isn’t wages for income tax withholding purposes, but is only treated as if it were wages, it isn’t taxable for FICA, the court concluded.

Hold your horses (or refund claims)

The IRS has a full hand of cards to play. It can request that the appeals court rehear the case, ask the U.S. Supreme Court to review it or continue to push the issue in other courts until it gets a ruling in its favor.

In the interim, it can issue an Action on Decision, in which it states that it will not honor the decision outside of the 6th Circuit.

If your company paid severance between 2009 and 2012, you can file a protective FICA refund claim (claims for severance paid in 2009 are due by April 15, 2013). For now, continue to withhold FICA taxes from severance pay in general, and from SUB pay in particular, unless those payments meet the current definition of SUB pay, which is discussed in IRS Pub. 15-A.

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