The Internal Revenue Service (IRS) has historically taken the position that severance payments are subject to payroll taxes. This position was supported by a 2008 decision from the U.S. Court of Appeals for the Federal Circuit in CSX Corp. v. United States (518 F.3d 1328). However, in the Sixth Circuit, the IRS position may change. Recently, the Sixth Circuit Court of Appeals affirmed a district court decision in U.S. v. Quality Stores, Inc. (No. 10-1563), holding that severance payments made to employees upon terminating their employment involuntarily because of business cessation, are not subject to Federal Insurance Contributions Act (FICA) taxes.
Quality Stores Inc. was seeking a refund of more than $1 million in FICA taxes it paid with regard to severance payments. The bankruptcy court and the district court both held that the payments were not subject to tax (40 DTR K-1, 3/3/10). The Sixth Circuit determined that the severance payments at issue qualified as supplemental unemployment compensation benefits (SUB) under Code Sec. 3402(o), which treats certain nonwage payments as if they were wages for income tax withholding purposes. Determining whether SUB payments constitute “wages” under FICA is complicated because the FICA statute and Treasury Department regulations do not address the issue.
For FICA or Federal Unemployment Tax Act (FUTA) purposes, SUB pay is defined solely through a series of administrative pronouncements published by the IRS. In Revenue Ruling 90-72, 1990-2 CB 211, the IRS asserted that the definition of SUB pay merits under Code Section 3402(o) is not applicable for FICA or FUTA purposes. The Revenue Ruling, which relies on a position first articulated in Revenue Ruling 56-249, 1956-1 CB 488, indicates that, to be exempt from FICA, SUBs must meet a number of unique conditions. For example, weekly benefits must be payable based on state unemployment benefits, or other compensation allowable under state laws.
The Court found that the Revenue Rulings relied on by the IRS to determine that the payments were subject to FICA were inconsistent with the intent of Congress. In Code Section 3402 and FICA, the definition of “wages” is almost identical. Under Code Section 3402(o), SUB payments generally are defined as amounts paid to the employee under the employer’s plan because of involuntary separation resulting from a reduction in force or similar condition that is included in the employee’s gross income.
In CSX in 2008, the Court of Appeals for the Federal Circuit reversed the Court of Federal Claims and held that the severance pay involved in the taxpayer’s various downsizing programs was subject to FICA. In a decision that created a split between Circuits, the Sixth Circuit Court of Appeals in Quality Stores expressly rejected the Federal Circuit’s holding in CSX that the payments were dismissal pay subject to tax (45 DTR K-1, 3/7/08). Accordingly, the Sixth Circuit allowed a refund of over $1 million in employer and employee FICA taxes paid on the severance payments.
Depending upon the result if the Sixth Circuit’s decision is appealed, this precedent may allow taxpayers in the Sixth Circuit to obtain refunds for FICA taxes paid on similar severance payments. Because the Sixth Circuit’s decision conflicts with the Federal Circuit’s holding in CSX, the Supreme Court could ultimately resolve the conflict between the circuits by making a determination as to whether severance payments are subject to FICA. If the IRS continues to pursue the Quality Stores matter, it could attempt to appeal the current case to the United States Supreme Court. Alternatively, the IRS may ask for a rehearing of the case in the Sixth Circuit. If the decision is not appealed, employers located in Kentucky, Michigan, Ohio and Tennessee (states in the Sixth Circuit) should be able to successfully pursue refund claims for FICA taxes paid on severance payments. Moreover, the ultimate decision in this matter could impact current compliance requirements, which present a separate issue for employers to consider with respect to future severance payments. Until there is a final decision, taxpayers generally are well advised to comply with IRS guidelines, but to preserve their rights through protective refund claims.
Downsizing is a fact of life in today’s challenging business environment and often results in severance payments to departing workers. This new decision could give companies that made such payments an opportunity to recover FICA taxes paid on the severance payments. However, any such refund claims must be filed within the applicable statute of limitations. For many taxpayers that have significant potential recoveries, protective refund claims should be considered as quickly as possible to avoid expiring limitations periods.