Court Ruling Could Open Door for Tax Refunds on Severance Payments

April 12, 2010 ( – A recent ruling by a federal court could mean the Internal Revenue Service owes companies, and their laid off workers, a tax refund on severance payments.

In February, the U.S. District Court for the Western District of Michigan upheld a Bankruptcy Court ruling that payments made to the employees pursuant to severance programs were not “wages” for purposes of FICA taxation. U.S. District Judge Janet T. Neff noted that for purposes of FICA, “wages” are defined as “all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash.” She rejected the IRS’ stance that severance payments made to former employees of Quality Stores were remuneration for employment.  

Neff also found the severance payments in this case meet the definition of “supplemental unemployment compensation benefits” (SUB) in IRS Code § 3402(o)(2), for which the IRS itself provides an exception to FICA as they are “certain payments made by an employer, conditioned on eligibility for and receipt of state unemployment benefits.”   

In addition, Neff pointed out that in1969, at the request of the Treasury Department, Congress amended Chapter 24 of the Internal Revenue Code (income tax withholding statutes) to solve the problem of “under withholding” faced by taxpayers who received SUB pay. The new tax withholding provision, 26 U.S.C. § 3402(o), ensured that SUB payments that were not deemed wages would be subject to income tax withholding by the employer.

Neff based her arguments in part on a 2002 Bankruptcy Court ruling in CSX Corp., Inc. v. United States. However, the IRS eventually won an appeal of that ruling, and was able to deny any refund claims it received after the Bankruptcy Court decision.  

The current case is United States of America v. Quality Stores, Inc.