Opinion analysis: Severance payments are wages – at least in most instances – for purposes of FICA

Bradley W. Joondeph is the Inez Mabie Distinguished Professor and Associate Dean for Academic Affairs at the Santa Clara University School of Law.

On Tuesday, the Supreme Court handed down two opinions in appeals from the United States Court of Appeals for the Sixth Circuit.  It affirmed the court’s judgment in one case and reversed it in the other.  The affirmance in Lexmark International, Inc. v. Static Control Components, Inc. ended a lengthy drought for the Sixth Circuit. The Court had reversed eleven straight appeals from the Cincinnati-based court – dating to May 26, 2011 – by a aggregate vote total of eighty-six to twelve.

But the Court’s affirmance in Lexmark was matched by a unanimous reversal in United States v. Quality Stores, Inc.  By a vote of eight to zero (with Justice Kagan recused), the Court held that the definition of “wages” for purposes of the Federal Insurance Contributions Act (FICA) includes severance payments made by an employer to its employees –or at least the type of severance payments made by Quality Stores in this case.  Thus, on the same day one streak ended for the Sixth Circuit, another may have begun.  Plus ca change.

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As detailed in the argument preview, the precise question presented in Quality Stores was whether a particular form of severance payments constituted “wages” under FICA, the federal payroll tax imposed on both employers and employees to fund the Social Security and Medicare programs.  Quality Stores faced financial difficulties in 2001, and it eventually entered bankruptcy proceedings. Both before and after filing its bankruptcy petition, the company offered its employees a series of severance packages, payable upon the employees’ separation from the company.  The amount of the payments depended on the employees’ positions in the company and their years of service.  The payments were not tied in any way to the receipt of state unemployment benefits – a matter to be discussed further below.

There was no question that the severance payments constituted income under the income tax, or that Quality Stores was required to withhold a portion of the payments for income tax purposes.  The only issue was whether the payments constituted “wages” for purposes of the payroll tax imposed by FICA.  The Sixth Circuit – affirming the judgments of the bankruptcy court and the district court – held that they were not, creating a split among the circuits. Justice Kennedy’s unanimous opinion for the Court reversed that decision.

As Justice Kennedy noted, the “beginning point” for the Court’s analysis was “the relevant statutory text” – namely, 26 U.S.C. § 3121(a), which defines the term “wages” under FICA.  Section 3121(a) states that wages are “all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash.”  Further, Section 3121(b) provides that “employment” encompasses “any service, of whatever nature, performed . . . by an employee for the person employing him.”  Given this definition, “and as a matter of plain meaning,” the Court concluded that severance payments constitute “remuneration for employment.”  They are paid to employees (or former employees), and they are typically based on such factors as the employee’s function and tenure with the employer.  In this way, they are “like many other benefits employers offer employees above and beyond salary payments,” such as “health and retirement benefits, stock options, or merit-based bonuses,” all of which plainly constitute “remuneration for employment.”

In the Court’s view, two other bits of evidence confirmed this reading of the statute. First, Section 3121(a)(13)(A) specifically excepts from the definition of “wages” severance payments that are made “because of . . . retirement for disability.”  This exemption would be unnecessary, Justice Kennedy explained, “were severance payments in general not within FICA’s definition of ‘wages.’”  Second, not long after the Social Security Act was originally enacted, the Treasury Department promulgated a regulation stating that, for purposes of the payroll tax, “dismissal pay” constituted “wages.”  In 1939, Congress overruled that regulation by statute, providing that wages did not include “[d]ismissal payments which the employer is not legally required to make.”  But in 1950, Congress repealed that provision, plainly indicating its view that the term “wages” includes severance payments.  And Congress has done nothing to alter the relevant portions of FICA since.

The Sixth Circuit had concluded that severance payments were not wages based not on these statutory provisions – those actually addressed to FICA – but instead on a provision concerning employers’ income-tax withholding obligations. Specifically, 26 U.S.C. §  3402(o) – captioned “Extension of withholding to certain payments other than wages” – states that “any supplemental unemployment compensation benefit paid to an individual . . . shall be treated as if it were a payment of wages by an employer to an employee for a payroll period.”  (Both the United States and Quality Stores stipulated that the disputed severance payments in this case constituted “supplemental unemployment compensation benefits,” also known as “SUB payments.”)  The Sixth Circuit inferred from this provision that such payments were not actually “wages” for purposes of income-tax withholding, and that FICA necessarily embraced the same definition of wages as that for income-tax withholding.

Closely tracking the arguments presented by the United States, the Court found this logic unpersuasive.  First, in directing all employers to treat SUB payments “as if” they were wages, Congress had not stated that all SUB payments were not wages.  Indeed, the more logical inference – given the regulatory history in this area – was that, regardless of whether any particular SUB payment falls within or without the definition, all such payments must be treated as wages for purposes of withholding.  (Otherwise, there is the risk that recipients will be hit with a huge, unexpected income tax liability at year’s end, without having set aside sufficient funds to satisfy that liability.)  In other words, Section 3402(o) just as easily reveals Congress’s recognition that at least some significant percentage of SUB payments are indeed “wages.”  Second, although statutory captions may sometimes be helpful in resolving statutory ambiguities, this caption “falls short of a declaration that all the payments listed in Section 3402(o) are not wages.”

Finally, the Court delved deeply in the regulatory history concerning SUB payments, explaining their complicated and varied historical treatment by the IRS.  To oversimplify a bit, in a long series of Revenue Rulings the IRS has declared that SUB payments that are tied to eligibility for state unemployment compensation are not wages under FICA, though they do constitute income.  The reason for this exemption is that, under some state laws, the receipt of “wages” from a former employer renders the recipient ineligible for state unemployment benefits – a result that would substantially undercut the utility of an employer’s SUB payment plan.  Thus, the IRS has long treated different SUB payments differently, depending on whether they are tied to state unemployment compensation.

To the Court, this history further illustrated why the Sixth Circuit had erred in its reading of Section 3402(o). Congress’s intent in enacting Section 3402(o) had been to declare that, regardless whether a particular SUB payment is tied to state unemployment compensation, the employer must withhold on the payment – and treat the payment “as if” it constitutes wages, whether or not it actually does so under the IRS’s various Revenue Rulings.

Interestingly, the Court concluded its opinion with a paragraph alluding to the arguable inconsistency in the IRS’s position.  If the SUB payments made by Quality Stores here (and severance payments more generally) are “wages” under the plain meaning of FICA, then how can the IRS continue to exempt from wages those SUB payments that happen to be tied to state unemployment compensation?  There may be policy justifications undergirding the Revenue Rulings carving out such an exemption, as explained above.  But how are those rulings consistent with the “plain meaning” of 26 U.S.C. Section 3121(a)?  In a thinly veiled warning to the government, the Court noted that “those Revenue Rulings are not at issue,” and that “[b]ecause the severance payments here were not linked to state unemployment benefits, the Court does not reach the question whether the IRS’ current exemption is consistent with the broad definition of wages under FICA.”

Those Revenue Rulings may now be vulnerable, especially given the Court’s broad reading of “wages” in Quality Stores.  But that is a question for another day – indeed, a day that may never come, given the difficulty of establishing standing to challenge the tax exemptions of other taxpayers.  In the meantime, cases like Schuette v. Coalition to Defend Affirmative Action give the Sixth Circuit the chance to jumpstart a healthy new streak at the Court.