The IRS has long held that severance payments from an employer to an employee are wages. As such, they are subject to income, as well as payroll taxes that include social security and Medicare. In a 2014 case (U.S. vs. Quality Stores) a Michigan court ruled otherwise – that social security and Medicare taxes are not due and payable on severance payments. The Sixth Circuit Court of Appeals, surprisingly, upheld the lower court ruling.
This ruling put the IRS in a bind. If the ruling were to stand and be applied nationwide, hundreds of millions of dollars could be at stake. Indeed, in a matter of months, over 3,000 claims for payroll tax refunds were filed with the IRS. All of these claims were disallowed if not coming from the Sixth Circuit. The IRS then appealed to the United States Supreme Court.
On February 9, 2015, the Supreme Court reversed the Sixth Circuit Court of Appeals decision, holding that severance payments are wages for payroll tax purposes. The court did construct a very narrow exception in cases where the payments may be linked to state unemployment benefits. Therefore, many companies who were dreaming of a huge tax windfall have had their hopes dashed. The IRS will disallow all claims for refunds of payroll taxes on severance payments that are outside the criteria laid down by the Supreme Court.