On September 7, 2012, in United States v. Quality Stores Inc., No. 10-1563, [pdf] the Sixth Circuit Court of Appeals found that employment taxes should not have been imposed on severance pay for hundreds of employees in an involuntary layoff.  The Court reasoned that the severance payments were not wages subject to the tax because the payments met the following five-part test:

  1. the payments were made to an employee;
  2. the payments were made under an employer’s plan;
  3. the payments were made because of an employee’s involuntary separation from employment;
  4. the involuntary separation from employment was due to a reduction in force, the discontinuance of a plant or operation, or other similar condition; and
  5. the payments were included in the employee’s gross income.

This decision could have wide implications as the taxes at issue were Federal Insurance Contribution Act (FICA) taxes that help pay for the United States Social Security retirement pension and Medicare health programs.  FICA taxes are paid by both employers and employees.  In Quality Stores, the employer sought approximately $1,000,125 of employment tax refunds on behalf of itself and the 1,850 former employees who agreed to allow the company to seek the refund on their behalf. 

This decision was particularly surprising because another federal court of appeals has come to the opposite conclusion on this same issue.  Although the Sixth Circuit admitted that its ruling created a conflict and that “the Supreme Court may ultimately provide us with the correct resolution[,] only Congress can clarify the statutes concerning the imposition of the FICA tax.”  The IRS may ask the Supreme Court to review and resolve the conflict.  In the meantime, employers in the Sixth Circuit (Ohio, Kentucky, Tennessee and Michigan) will have to decide whether they will rely on this decision as a basis to withhold FICA from severance payments in layoff circumstances or wait until the decision is resolved by the Supreme Court.  Another option is for employers to withhold the tax and then request a refund.

Either way, it is likely this won’t be the last word on this issue and that we will see numerous companies apply for employment tax refunds if the payments meet the test above.