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Sixth Circuit Upholds Ruling That Certain Severance Payments Are Not Subject to FICA Tax

October 3, 2012

In United States v Quality Stores, Inc. , 2012 U.S. App. LEXIS 18820 ( CA 6, 2012), the United States Court of Appeals for the Sixth Circuit affirmed the district court's holding that "supplemental unemployment compensation benefits" (SUB payments), a form of severance payment, made to involuntarily terminated employees were not classified as wages for FICA purposes.

In Quality Stores , the company commenced a voluntary Chapter 11 bankruptcy case.  As part of the bankruptcy, Quality closed a number of stores and distribution centers.  This led to a termination of all its employees.  Quality developed two severance plans, the pre-petition and post-petition plans.

The pre-petition plan was based on job grade, management level, and the number of months or weeks employed by Quality.  The severance payments were not tied to the receipt of state unemployment compensation and were not attributable to the provision of any particular services by the employees.  The payments were made on the normal payroll schedule.

The post-petition severance plan was designed to encourage employees to remain with the company by assuring them severance pay if their jobs were eliminated.  Employees were eligible for severance pay if they completed the last day of service as scheduled.  The post-petition severance amounts were not tied to the receipt of state unemployment compensation and were not attributable to the employee providing any particular service.

Quality reported the payment of severance as wages and withheld both the employer's and employee's share of the FICA taxes.  However, Quality took the position that the severance payments were SUB payments.  It argued that the IRS should refund the FICA payments because SUB payments were not taxable wages under FICA.  When the IRS rejected this argument, Quality brought an adversary action in the bankruptcy court.  The bankruptcy court and the district court found that the severance payments were SUB payments and not taxable wages under FICA.  The IRS appealed to the Sixth Circuit.

The Sixth Circuit affirmed the district court's decision.  The court found that there were five separate elements to SUB payments: " (1) an amount paid to an employee; (2) pursuant to an employer's plan; (3) because of an employee's involuntary separation from employment, whether temporary or permanent; (4) resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions; and (5) included in the employee's gross income. "

The parties stipulated that (1) Quality made the payments to employees; (2) pursuant to a company plan; (3) because of the employees' permanent separation from employment; and (4) resulting directly from a reduction in force or the discontinuance of a plant or operation.  Finally, the court concluded that the SUB payments were included in the employees' gross income, citing Internal Revenue Code § 61.  The court found that the statutory definition did not require that SUB payments be tied to an employee's receipt of state unemployment compensation benefits, nor did the statute make any distinction between periodic payments or one-time payments made in a lump sum.  The court concluded that Quality's payments were not wages as defined by the FICA statute and therefore were not subject to FICA payments.

For clients whose severance payments include facilities and employees located in Michigan, Ohio, Kentucky and Tennessee, the decision in Quality controls and companies do not have to pay FICA tax on SUB payment.  Employers who are contemplating reductions in force, discontinuance of a plant or operation or other actions should determine whether the related severance payments meet the requirements of a SUB plan payment.  Employers that have already paid severance benefits that could qualify as SUB plan benefits may want to consider filing a protective claim for refunds for years for which the statute of limitations has not run.  However, the Quality Store decision is at odds with the Federal Circuit's decision in CSX Corp. v United States , 518 F3d 1228 (CA Fed, 2008). Given the conflict between the circuits, it is likely that the United States will appeal this decision to the Supreme Court.

If you have any questions about whether a severance plan qualifies as a SUB payment under the Internal Revenue Code, please contact Thomas P. Brady at (313) 965-8291 or

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