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Companies must pay taxes on severance payments: U.S. high court

The exterior of the U.S. Supreme Court is seen in Washington March 5, 2014. REUTERS/Gary Cameron
The exterior of the U.S. Supreme Court is seen in Washington March 5, 2014. REUTERS/Gary Cameron

By Lawrence Hurley and Patrick Temple-West

WASHINGTON (Reuters) - The U.S. Supreme Court ruled on Tuesday that taxes are due for Social Security and Medicare on severance packages paid to workers who are laid off involuntarily, overturning a lower court ruling that could have led to a wave of payroll tax refund requests from U.S. businesses.

In a win for the Obama administration and the U.S. Internal Revenue Service, the court voted 8-0 that Quality Stores Inc., a defunct retailer, and its employees are not entitled to tax refunds totaling about $1 million.

The tax refund at issue was small, but the IRS said the stakes in the case were huge because, if Quality Stores had won, thousands more refund claims could have resulted, possibly totaling as much as $1 billion.

If Quality Stores had won, many companies were ready to file for tax refunds, said Ruth Wimer, a partner at the law firm McDermott Will & Emery LLP, calling the decision "bad news" for employers and employees.

The dispute centered on whether severance paid to involuntarily terminated workers was taxable under the Federal Insurance Contributions Act tax, or FICA, which helps pay for Social Security pensions and Medicare health insurance for the aged. FICA tax is paid by a company and its employees.

In September 2012, the 6th U.S. Circuit Court of Appeals ruled that Quality Stores' severance payments to its former employees were not wages and so were not taxable under FICA.

That decision was overturned by the Supreme Court, with Justice Elena Kagan recused in the case. "Under FICA's broad definition, these severance payments constitute taxable wages," said Justice Anthony Kennedy, in an 18-page opinion.

SEVERANCE IN TAX GRAY AREA

Quality Stores served farmers and small-town people in 300 locations. It declared bankruptcy in 2001 and laid off thousands of workers with severance pay. The company withheld FICA tax from the severance and sent the withholdings to the IRS.

In oral arguments before the high court in January, the IRS and Quality Stores argued over seemingly contradictory language in the tax code related to severance pay and FICA taxes.

One part of the code defines wages as "all remuneration for employment." But in a different code section, "supplemental unemployment benefits (SUB)" are exempted from income taxes.

Quality Stores argued that its severance payments were exempt from FICA tax under the "SUB payments" definition.

The Supreme Court dismissed this argument.

"Severance payments are not exempted, and they squarely fall within the broad textual definition of wages for purposes of income-tax withholding," the court said.

(Editing by Kevin Drawbaugh and Grant McCool)

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