United States v. Quality Stores, Inc., 2012 FED App. 0313P (6th Cir., 9/7/12) has created a split among the Circuits on whether severance payments to workers discharged as a result of facility closures are subject to FICA tax. The Federal Circuit upheld the decision that the wages are indeed subject to FICA tax in CSX Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008). However, the new decision by the Sixth Circuit disagrees.

The case arose out of the bankruptcy of Quality Stores, which resulted in the closing of all of its facilities and the termination of its 3,100 employees. The company had a severance pay plan under which workers, who were involuntarily separated as the result of a closing, were entitled to lump sum payments based on their length of service. There was no question that these payments were subject to income tax withholding, as they are explicitly covered by IRC, §3402(o). At issue was whether FICA tax had to be withheld, too.

In a series of rulings (most recently Revenue Ruling 90-72), the IRS has created an administrative exclusion from FICA wages for severance payments where conditions for receipt closely track those for state unemployment compensation. Quality Stores’ payments did not meet those conditions, but the company applied for FICA tax refunds on the theory that payments on involuntary severance are not “remuneration for employment” and hence are not included in FICA’s definition of “wages.” The foundation of the company’s argument was an inference from §3402(o), which requires income tax withholding on “supplemental unemployment benefits” (SUB) and states, in particular, that a SUB payment “shall be treated as if it were a payment of wages by an employer to an employee for a payroll period.” (Emphasis added.) The reasoning was that “as if” wages are, by implication, not “real” wages. Since FICA is imposed only on “wages,” it follows what §3402(o) defines as “supplemental unemployment benefits” as FICA-exempt. That definition is expansive: “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.”

The CSX court denied the proffered inference. In its view, the “as if” language merely ensured that no SUB benefits, including those that the IRS administratively treated as non-wages for FICA purposes, would escape income tax withholding. As a general proposition, in the Federal Circuit’s view, severance payments derived from the employer-employee relationship and therefore were “remuneration for employment.”

The Sixth Circuit agreed with CSX on one fundamental point: “wages” are defined in the same way for both income tax and FICA purposes, as the Supreme Court held in Rowan Cos. v. United States, 452 U.S. 247 (1981). Although a later statute aimed to decouple the two definitions, both courts held that, regardless of the Congress’s intent, the actual language of the law did no more than authorize the IRS to define the term differently in the two realms, which it has not done except to the extent provided in Revenue Ruling 90-72 and its predecessors. The upshot, said one court, is that severance payments are both income tax and FICA wages; the other, that they are neither even if they have been subjected to income tax withholding by §3402(o)’s fiat.

The analysis in the Quality Stores opinion starts with what is practically a throwaway reference to a Supreme Court decision, Coffy v. Republic Steel Corp., 447 U.S. 191 (1980) whose lesson, the opinion states, is “that SUB pay falls outside the broad statutory meaning of service performed by an employee for an employer because, by definition, an employee is not eligible for SUB pay until service to the employer has ended and such benefits provide compensation for the lost job.” This case will not bear much weight, however, because it involved veterans’ reemployment rights rather than FICA. The dispute was over whether an employee’s entitlement to severance pay was a “seniority right” (meaning that his military service had to be taken into account in determining the amount) or a form of deferred compensation. The Supreme Court concluded that the benefits at issue stemmed from seniority, have no obvious bearing on whether they are “wages.”

After that prelude, the opinion delves into the legislative history of §3402(o). The essence of its conclusion is that Congress believed that all “supplemental unemployment benefits,” as defined in that section, were “payments other than wages” and that the IRS’s narrower exclusion (which predated the statute) therefore defied Congressional intent.

At the close of the opinion, the courts says, in a rueful tone,

We agree with the Federal Circuit on one final important point: “We acknowledge that this issue of statutory construction is complex and that the correct resolution of the issue is far from obvious.” CSX Corp., 518 F.3d at 1340. While the Supreme Court may ultimately provide us with the correct resolution of these difficult issues under the law as it currently stands, only Congress can clarify the statutes concerning the imposition of FICA tax on SUB payments.

Given the clear split between the Circuits and the fact that SUB plans, in a variety of forms, are widespread, this case looks like a prime candidate for certiorari. Pending resolution by the Supreme Court, companies that have paid FICA tax on SUB benefits, as defined in §3402(o), may wish to file protective refund claims. They can also file claims for the employees, with their consent, by filing Form 843. If certiorari is not granted, the IRS will most likely grant refunds within the jurisdiction of the Sixth Circuit while continuing to contest them elsewhere.