Taxation of supplemental payments can be one of the most confusing areas of tax law that employers can face. Severance or dismissal pay must be included in the terminated employee’s taxable income. It is also subject to federal, state, social security, Medicare, and FUTA taxes. According to the IRS, severance pay must also be treated as supplemental wages and taxed at state and federal supplemental rates.
Recently, a decision by the Sixth Circuit Court of Appeals appeared to directly conflict with the IRS regulations. In United States v. Quality Stores, Inc., the Sixth Circuit ruled that severance payments made in connection with a layoff or reduction-in-force are exempt for social security taxes. (6th Cir. 2012). The court further stated that employers who have made social security payments on severance pay should file refund claims.
On October 2, 2013, The U.S. Supreme Court agreed to review this decision. This means that a ruling originally confined to states in the Sixth Circuit—Kentucky, Ohio, Michigan, and Tennessee—could have national ramifications. It is currently recommended that employers who made severance payments due to a reduction-in-force consider filing for a refund of those payments using form 941-X. Employers are able to request a refund for the tax period beginning in 2010.