Court Rules Severance Pay Not Subject to FICA

The law on whether or not employers should withhold payroll taxes on severance payments is not settled.

Getting laid off is bad enough; but, to add insult to injury, FICA taxes (Social Security and Medicare taxes) are routinely withheld from severance payments to laid off workers and paid to the IRS. One court has ruled this is wrong, but the issue remains unsettled.

Ordinarily, employees and employers each pay a 6.2% Social Security tax on employee wages up to an annual cap, plus a 1.45% Medicare tax on all wages, for a total 15.3% tax up to the annual cap. Together these taxes are known as FICA, payroll, or employment taxes. The employer withholds the employee's taxes from his or her pay and sends it to the IRS along with its own matching payments. So this is money the employee never sees.

FICA taxes must be paid only on employee wages. Do "wages" include severance payments made to workers who are involuntarily laid off? This question arose when Quality Stores laid off a substantial number of workers after it filed for Chapter 11 bankruptcy and closed several stores. To its credit, Quality gave its laid-off workers severance pay. Salaried employees received an average of 11.4 weeks of severance pay, while hourly employees averaged 4.2 weeks. Quality withheld and paid FICA on these payments, but it, and 1,850 former employees joined together to file a claim for refund to get the FICA payments back. The IRS refused, and Quality went to court.

The court held that severance payments (also called "supplemental unemployment compensation") are not subject to FICA. Reason: they do not come within the tax law's definition of employee wages because they were not compensation for work performed.

The IRS disagrees with the court's holding and has appealed. Meanwhile, another federal court has held that such payments are subject to FICA. Thus, this legal question remains unsettled and the IRS continues to require employers to pay and withhold these taxes from severance payments. The United States Supreme Court may have to resolve this legal issue--a process that could take years.

Meanwhile, hundreds of companies have already paid and withheld billions of dollars on employee severance payments. Many have filed their own claims for refund with the IRS. Pending refund claims currently amount to over $2 billion. There is a three year statute of limitations on such claims--that is, only payments going back no more than three years are affected.

If these refund claims ultimately prove successful, the employers will get back the employer portion of FICA they paid themselves. But what about the employee portion of FICA withheld from the employees' paychecks? This belongs to each employee, not the employer.

Don't worry, your former employer can't pocket this money. The company has to distribute to each former worker his or her share of refunded FICA taxes when the IRS pays it.

If you were laid off and had FICA taken out of your severance pay, you should ask your former employer if it has filed a claim for refund (if it has not told you already). If not, you can file your own claim by filing IRS Form 843. However, it will be easier if your ex-employer files a claim that you can join.

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