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Employers May be Eligible for Payroll Tax Refund on Severance Benefits

Added by John McGown, Jr. in Articles & Blogs, Tax Law on December 18, 2013

The issue of whether payroll taxes (i.e., Social Security and Medicare) are due on severance payments made to terminated workers in connection with an employer’s reduction in force is before the United States Supreme Court. The case is U.S. v. Quality Stores and oral arguments are scheduled to begin January 14, 2014. The issue of whether severance is exempt from employment taxes has been a matter of hot debate between the IRS and the courts, becoming particularly acute in the aftermath of the economic collapse in 2008 and later.

Most recently, the issue of the taxation of severance paid as supplemental unemployment benefits arose in the Sixth Circuit (Ohio, Kentucky, Michigan, and Tennessee) when the Sixth Circuit Court of Appeals last year in a pro-taxpayer ruling rejected the IRS’ long-held position on the taxation of severance paid as supplemental unemployment benefits. In that ruling, the Sixth Circuit Court of Appeals broadened the types of severance pay that may qualify as supplemental unemployment benefits that are exempt from payroll taxes.

The IRS disagreed with the Sixth Circuit’s ruling and requested that the U.S. Supreme Court hear the case. In anticipation of the Supreme Court’s final resolution of what constitutes supplemental unemployment benefits for employment tax purposes, taxpayers who paid payroll taxes on severance pay in connection with a reduction in force have filed protective refund claims with the IRS for more than $1 billion in Social Security and Medicare taxes.

Because of the statute of limitations, the Supreme Court’s ruling has the greatest potential to affect payroll taxes on severance payments made in 2010 or later, although in some situations the ruling may affect amounts withheld before 2010. Accordingly, employers should review their records to determine if they paid payroll taxes on severance payments made in 2010 or later in connection with a reduction in force. If payroll taxes were paid, then employers should strongly consider filing a protective refund claim for the previously paid taxes – generally before March 15, 2014.

We have significant experience in designing severance programs that comply with the requirements that the Sixth Circuit identified as necessary to exempt severance pay from employment taxes. Please let us know if you would like our assistance designing this type of plan or evaluating whether prior severance payments may qualify for an employment tax refund.

For more information about this or other tax matters, please contact John McGownBret Busacker or Rick Smith or call 208.344.6000.