Recently, the federal appellate court covering Ohio, Kentucky, Tennessee, and Michigan ruled that an employer is entitled to a refund of Federal Insurance Contribution Act (FICA) taxes which had been withheld from severance payments made to employees who were terminated in a reduction in force (RIF). United States v. Quality Stores, Inc. (Sixth Circuit Case No. 10-1563, September 7, 2012). FICA payments are made both by the employee, through withholding from wages, and the employer, and the taxes are designated to support the social security and Medicare programs.
The Quality Stores decision surprised many observers, because it reached a different conclusion from the other federal appellate court that addressed the issue. Thus, this decision may harbor a significant change in the way severance payments are treated for FICA tax purposes, and employers (and employees) who have recently paid FICA taxes on severance payments may want to consider requesting a refund from the Internal Revenue Service (IRS).
What are the facts of the Quality Stores case?
Quality Stores underwent several RIFs, where jobs were eliminated and stores were closed. Employees whose jobs were eliminated as a part of these RIF received severance packages under plans developed by Quality Stores. Under these plans, employees were paid a certain number of weeks of severance, and the amount of severance each employee received varied depending on the employee's position within the company and the employee's years of service with the company. Some employees were paid over a period of time in accordance with the company's payroll schedule, while others received a lump sum payment. Following the applicable guidance from the IRS, Quality Stores withheld FICA taxes from the employees' severance checks, and also paid its share of the FICA taxes on such payments to the IRS. Subsequently, however, Quality Stores made a request for refund of the FICA payments from the IRS, arguing that the payments were not "wages" for purposes of that tax. The IRS disagreed, and the matter was initially resolved by a bankruptcy court in Quality Stores' favor. Then, in its 21-page decision released last week, the Sixth Circuit analyzed all of the competing – and often conflicting – statutory and regulatory provisions and concluded that the FICA tax was not required to be withheld from the severance payments, and that Quality Stores is therefore entitled to a refund.
Why did the court rule this way?
The court concluded that the severance payments were not wages, and therefore not subject to the FICA tax, because the payments met each of the following criteria: (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.
What will the IRS' response to the Quality Stores decision be?
At this point, the IRS has not indicated how it will respond to the Quality Stores decision. Especially because another federal court of appeals has come to the opposite conclusion on the same issue, the IRS may ask the United States Supreme Court to resolve the conflict once and for all. The tax code could also be amended by Congress to provide clearer guidance, but any legislative change should be prospective only.
What are the options for employers and individuals who have paid FICA taxes on severance payments?
Employers (and employees) who have paid FICA taxes on severance payments might consider filing a request for refund, especially if they are located in Ohio, Kentucky, Tennessee, or Michigan. While we do not know how the IRS will treat FICA refund requests raising this issue, employers are unlikely to get more time to file refund requests. Generally, refund requests must be filed within three years after the tax return was filed, and if an employer fails to file a timely claim for refund, the overpayment of tax cannot be recovered. Similarly, employers who implement a RIF in Ohio, Kentucky, Tennessee, and Michigan have a basis not to withhold FICA from severance – if the employer is willing to risk that the Quality Stores decision will not be overturned by the Supreme Court and/or potential IRS inquiries. A more conservative alternative might be to continue to withhold and pay the tax, but then request a refund.