The Federal Circuit Court of Appeals recently reversed an April 2002 decision by the U.S. Court of Federal Claims regarding FICA taxation of severance pay.  That lower court generally held that certain severance pay was not subject to FICA because it constituted “supplemental unemployment compensation benefits” (“SUB” pay) under a Tax Code definition of “amounts which are paid to an employee, pursuant to a plan to which the employer is a party, because of an employee’s involuntary separation from employment (whether or not such separation is temporary), resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions, but only to the extent such benefits are includible in the employee’s gross income.”

The Federal Circuit Court noted that “dismissal pay” is generally subject to FICA tax while SUB pay is not.  It went on to clarify that the SUB pay definition above pertains only to defining pay that would be subject to federal income tax withholding.  For purposes of determining severance pay that is SUB pay not subject to FICA (as well as FUTA), employers must look to prior IRS Revenue Rulings.  Most significantly, such guidance requires that there be a link between the SUB pay and state unemployment compensation.  Since this link does not exist in typical severance pay arrangements, most employers must treat all severance pay as subject to FICA.  However, employers considering a reduction in force or discontinuance of a plant or operation, with the intent to provide severance payments, may find it worthwhile to look to such prior guidance to see whether a link to state unemployment compensation can be established, and other necessary conditions can be satisfied, whereby FICA and FUTA taxes might be avoided.