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Justices Say Severance Payments Must Be Taxed

WASHINGTON (CN) - Severance payments made to laid-off workers are subject to payroll tax, the mostly unanimous Supreme Court ruled Tuesday.

Agricultural-specialty retailer Quality Stores had brought the challenge as an adversary action in bankruptcy court after the Internal Revenue Service declined to refund just over $1 million in taxes under the Federal Insurance Contributions Act (FICA).

Quality Stores had withheld the funds even though it viewed the payments as Supplemental Unemployment Benefits, or SUB pay, rather than wages, when it was forced into Chapter 11 bankruptcy in 2001.

It asked 3,100 former employees to let it file tax-refund claims on their behalf. Of those contacted, 1,850 former employees said yes.

Before the Supreme Court's decision Tuesday, each decision has favored the claim of Quality Stores that the severance payments are not taxable income.

Justice Elena Kagan took no part in the consideration or decision of the case, and the justices were otherwise unanimous in reversing the 6th Circuit's ruling.

"A specific exemption under FICA for certain termina­tion-related payments reinforces the conclusion that the payments in question are well within the definition of wages," Justice Antony Kennedy wrote for the court. "Section 3121(a)(13)(A) exempts from taxable wages any severance payments made 'because of ... retire­ment for disability.' That exemption would be unneces­sary were severance payments in general not within FICA's definition of 'wages.'"

It is indisputable that severance payments "squarely fall within the broad textual definition of wages for purposes of income-tax withholding under §3401(a)," the 15-page opinion states.

"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," Kennedy concluded. "Under FICA's broad definition, these severance payments constitute taxable wages."

Pepper Hamilton partner Bob Hertzberg, the attorney for Quality Stores, called Tuesday's decision "a huge blow for employers and employees alike."

"In addition to the impact on Quality Stores and its former employees, this ruling has far-reaching implications for the thousands of other organizations and workers fighting for refunds," Hertzberg said in a statement.

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