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I’ve had some time now to review the US Supreme Court’s Quality Stores opinion, in which the court recently ruled that payments pursuant to severance agreements are “wages” within the meaning of the Federal Insurance Contributions Act, and therefore subject to social security taxes, which must be withheld from the payments.  That means severance payments will now be 7.65% less valuable to departing employees (because social security taxes of 6.2% and Medicare taxes of 1.45% will be deducted), and cost former employers 7.65% more (because employers must match those tax payments).

First, such payments have always been “income”, so the decision does not lessen or increase income tax liability, nor create any new obligation to withhold income taxes from severance payments.

Second, employers and employees who are negotiating severance packages will want to take the decision into account. If the departing employee has already reached the Social Security earnings cap of $113,700, there will be no additional tax obligation on the severance pay paid in the same year; but delaying such payments into the following year will cause those payments to be subject to the social security taxes.  Conversely, realizing the severance payments in the current year will mean that the severance payments may be taxed at the marginal income tax rate, while, if payments are delayed to a new tax year, in which the former employee anticipates less income (owing to being out of a job), overall taxes might be lower. So, tax planning in such negotiations will be more complicated. Also, many severance packages provide for modest amounts; perhaps the same money would be better spent, more valuable to the departing employee, and less expensive to the employer, in the form of continued employer contributions to health insurance benefits post-termination (during the COBRA period).

Third, the court stressed that the severance payments were keyed to time in service and position, and were paid in connection with the company’s layoffs. So the decision does not mean that settlements of claims that arise after termination, or even those in connection with ongoing employment, are necessarily subject to the tax. Common practice in employment claim settlements is to make a good faith determination of what portion of the recovery can fairly be attributed to “back pay” and treat that portion as “wages” subject to withholding, while making separate payments of what amount to non-wage payments (e.g., compensation for emotional distress or attorney’s fees), and made the subject of a 1099 (and which may or may not comprise “income”).

Last, there’s no profit in arguing that a Supreme Court decision was “wrong”; especially one, like this one, that was unanimous.  But, as the Court observed in its opinion, at one time, severance payments were among those items listed in 26 U.S.C. Sec. 3121(a) expressly excluded from the definition of wages (and the repeal of that express exemption suggested, the court reasoned, that Congress didn’t intend for severance payments to be excluded any longer).  Common sense, it seems to me, counsels in favor of amending Section 3121 to restore that exemption.  “Wages” are paid by employers to employees.  Severance payments are paid by former employers to former employees.  “Wages” are paid to employees in exchange for work.  Severance payments are paid to former employees in exchange for waivers of various claims (You don’t agree? Ask any employer if they will make the severance payments if the former employee crosses out the waivers from the severance agreement).  Workers who have lost their jobs need 100% of whatever their former employer is willing to provide to tide them over until they can secure new employment; social security doesn’t provide any benefit to them during this period of hardship, and the fund ought not to be financed with any portion of severance payments.

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