FICA Taxation of Severance Pay May Remain Thorny Issue Due To Conflicting Rulings
January 11, 2013
Conflicting court rulings may lead to confusion and dispute over whether employers are required to pay Federal Insurance Contributions Act tax – or FICA taxes – on severance payments made to former employees.
The issue has been a contentious one, with the Internal Revenue Service asserting that severance payments are considered wages under tax law unless they meet specific conditions that would instead qualify them as supplemental unemployment benefits. Failing to meet the latter conditions would make severance payments subject to FICA taxation.
Under the narrow terms of the supplemental unemployment benefits exclusion, payments made on account of a worker’s involuntary termination due to a reduction in job force or closing of a facility may not be subject to FICA taxation, according to the IRS. In addition, payments must not be made in a lump sum, but instead made in a series of payments to complement state unemployment benefits.
In 2008, the Federal Circuit agreed with the IRS stipulations, noting that severance payments that fell outside the scope of the supplemental unemployment benefits definition are subject to FICA taxes, according to Bloomberg. However, a more recent ruling by the Sixth Circuit court resulted in more ambiguity by rejecting portions of the 2008 ruling. For example, the Sixth Circuit ruled that payments made in a lump sum to employees due to an involuntary separation from employment which stems from a reduction in force or the closing of a facility are exempt from FICA taxes. The court also noted that the payments do not have to be designed to supplement state benefits to be exempt from FICA.
As a result of the most recent ruling, many employers may now consider whether to request refunds from the IRS for FICA payments made in previous years. However, if the IRS chooses to appeal the ruling, it may continue to cause confusion.