In 2002, Quality Stores, Inc. filed an amended return seeking an IRS refund for around $1 million paid in FICA taxes withheld from severance pay. Quality Stores, Inc. argued that severance payments are not payment for services, but rather payments for "the elimination of employment." As such, Quality Stores, Inc. argued that severance payments are not subject to FICA taxes, but rather regular income taxes. Both the district and appellate courts agreed finding that the severance payments that conformed to IRC §3402(o) are not subject to FICA taxes if: (1) made to employees; (2) pursuant to a company plan; (3) due to the employees' permanent separation of employment; (4) resulting directly from a reduction in force, plant closing, or similar closing of a business; and (5) the payments were included in the employees' gross incomes. The IRS disagreed and petitioned the U.S. Supreme Court for review.

In accepting United States v. Quality Stores, Inc. for review, the Supreme Court will reconcile the conflict among the circuits, as the Federal Circuit Court in CSX Corp. v. United States, 518 F. 3d 1328 (Fed. Cir. 2008), which initially held that involuntary layoff payments are exempt from FICA taxes, only if the payment qualifies as "supplemental unemployment compensation benefits" ("SUB Pay") pursuant to IRS Code §3402(o)(2). However, on appeal, the Federal Circuit reversed the Court of Federal Claims holding that involuntary severance payments were in fact wages subject to FICA taxes.

Pending resolution either by the US Supreme Court, or earlier by the promulgation of additional regulations from either the IRS or Congress, employers should continue to withhold and pay FICA taxes on severance payments, and simultaneously file a protective refund claim with the IRS.

IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you that, to the extent this communication concerns any tax matter, it was not written to be (and may not be) relied upon to (1) avoid tax-related penalties under the Internal Revenue Code, or (2) promote, market or recommend to another party any transaction or matter addressed.