Severance Pay FICA Tax Treatment May Change

In a decision having significant impact, the Sixth Circuit ruled that payments to employees as part of a severance program are not subject to tax under the Federal Insurance Contributions Act, or FICA. The IRS is fighting the decision. Employers should file protective claims before the statute of limitations runs out.

The case involves whether the income tax treatment of severance payments can be decoupled from the FICA treatment for the same wages. Supplemental Unemployment Compensation Benefits (SUB) are exempt from FICA taxes. SUB payments to employees are excluded from the definition of “wages” for FICA purposes IF the amounts are paid to an employee:

  1. Because of an employee’s involuntary separation from employment; and
  2. Resulting directly from a reduction in force, the discontinuance of a plant or other similar conditions (IRC §3402(o)(2)(A).)

The ruling places the Sixth circuit in direct conflict with the Federal Circuit, where the Internal Revenue Service (IRS) won in re: CSX Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008). The CSX decision held that to be exempt from FICA, severance payments must meet the requirements of Revenue Ruling 90-72 and Revenue Ruling 56 249, which are more restrictive than the requirements summarized above. Under Rev. Rul. 90-72, to be exempt from “wages” under FICA, SUB payments must be made pursuant to a plan designed to supplement state unemployment compensation. Accordingly, severance pay is exempt from FICA as a SUB only if linked to the continued receipt of state unemployment benefits. Additionally, the IRS ruled that lump sum payments are not linked to state unemployment compensation and therefore are not excludable from FICA.

Because of the wide application of this issue to all of the layoffs that occurred during the recent downturn, and the clear Circuit split, a good chance exists that the Supreme Court will accept the case. Congress could also resolve the issue to avoid making the deficit worse.

Additional information regarding both cases, and how to file a refund claim are contained in this article.


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