Can Severance Pay Be Taxed? Justices to Decide

(CN) - The Supreme Court on Tuesday said it will determine whether severance payments made to laid-off workers are subject to payroll tax.

The justices agreed to hear U.S. v. Quality Stores, which involves the payments made to workers and executives who were laid off when Quality Stores was forced into Chapter 11 bankruptcy.

Its president and CEO received 18 months of severance pay, senior managers received one year, and all other managers and employees received one week per full year of service.

The payments were not tied to any work but were instead designed to encourage workers to defer their job searches by assuring them they would get severance pay if their positions were cut.

Though Quality Stores withheld tax under the Federal Insurance Contributions Act (FICA), it viewed the payments as Supplemental Unemployment Benefits, or SUB pay, rather than wages.

It asked 3,100 former employees to let if file tax refund claims on their behalf. Of those contacted, 1,850 former employees said yes, and the company sought a FICA tax refund of just over $1 million.

When the IRS declined to refund the money, Quality Stores filed an adversary action in bankruptcy court, where a judge agreed that the severance payments are not taxable income.

A federal judge came to the same conclusion, and the 6th Circuit affirmed on appeal.

"Congress did not consider SUB payments to be 'wages,' but allowed their treatment as wages to facilitate federal income tax withholding for taxpayers," Judge Jane Stranch wrote.

The government pointed out that the lower court's finding contradicts various IRS revenue rulings.

But the 6th Circuit found that argument unconvincing.

"Congress, not the IRS, prescribes the tax laws," Stranch wrote.

In its conclusion, the 6th Circuit seemed to anticipate Supreme Court intervention, saying the high court "may ultimately provide us with the correct resolution of these difficult issues under the law."

The justices will decide "whether severance payments made to employees whose employment was involuntarily terminated are taxable under the Federal Insurance Contributions Act."

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