Severance pay for laid-off workers is taxable, Supreme Court rules

Outside the U.S. Supreme Court
Snow falls outside the Supreme Court in Washington, D.C., on Tuesday.
(Michael Reynolds, European Pressphoto Agency)

The U.S. Supreme Court ruled in favor of the Obama administration in a dispute over taxes on severance compensation, overturning a lower court decision that could have forced the IRS to refund more than $1 billion.

The court said that payments to laid-off workers are subject to Social Security and Medicare taxes under the Federal Insurance Contributions Act, or FICA. It was a victory for the Internal Revenue Service, which has been fighting more than 2,400 refund claims from companies and their former employees.

The unanimous ruling came in the case of Quality Stores Inc., once the country’s largest agricultural specialty retailer. The defunct company fired 3,100 workers when it closed its stores in 2001 and 2002, paid the taxes on their severance and then asked the IRS for refunds of about $1 million. When the IRS refused, Quality Stores sought relief in Bankruptcy Court.

The company contended that what it called supplemental unemployment compensation was exempt from the FICA.

Writing for the court, Justice Anthony Kennedy said the taxes were legally withheld.

“The severance payments here were made to employees terminated against their will, were varied based on job seniority and time served and were not linked to the receipt of state unemployment benefits,” he wrote. “Under FICA’s broad definition, these severance payments constitute taxable wages.”

Lower courts were divided on the issue. The high court ruling came in the government’s appeal of a September 2012 decision by a Cincinnati-based U.S. appeals court that said Quality Stores was entitled to a refund. The money would have gone to 1,850 former employees who paid their share of the taxes and authorized Muskegon, Mich.-based Quality Stores to try to recoup the payments on their behalf.

FICA uses payroll taxes to finance Social Security and part of the Medicare healthcare program for the elderly and disabled. Employers and employees each pay 6.2% in Social Security taxes on wages up to a cap, which is $113,700 this year, and they each pay 1.45% of all wages toward Medicare. High-income taxpayers are subject to additional payroll levies.

According to a brief filed by the Obama administration, the claims for refunds have been made in 11 unresolved lawsuits and 2,400 administrative cases “with a total amount at stake of more than $1 billion.”

“That figure is expected to grow,” the brief said.