On September 7, the Sixth Circuit Court of Appeals issued a decision (United States v. Quality Stores, Inc.) holding that certain severance payments are not "wages" subject to Federal Insurance Contributions Act (FICA) tax, and upheld a bankruptcy court’s decision ordering a full refund of more than $1 million of FICA taxes paid by an employer with respect to severance payments it made to employees whose positions were eliminated in connection with the bankruptcy. This decision creates an opportunity for employers in the Sixth Circuit (which includes Tennessee, Kentucky, Ohio, and Michigan) to claim refunds for FICA taxes previously paid with respect to certain limited types of severance payments.
Facts of the Case
Quality Stores, Inc. was the largest agricultural-specialty retailer in the country. Quality Stores made severance payments to 3,100 employees whose employment was involuntarily terminated in connection with the closing of numerous stores and distribution centers. The payments were made pursuant to two separate severance plans that set forth the terms of the severance payments, including eligibility requirements, amount of severance and form of payment. The plans did not require employees to prove that they were unemployed or tie severance payments to the receipt of state unemployment compensation. Quality Stores withheld federal income tax and the employees’ share of FICA tax from the severance payments and paid the employer’s share of FICA tax on the severance payments.
Although Quality Stores paid the FICA tax, it did not agree with the position of the Internal Revenue Service (IRS) that the severance payments constituted “wages” subject to FICA tax. As such, Quality Stores subsequently filed a claim with the IRS seeking a refund of FICA tax which it had paid. The claim included the employee’s share of FICA tax on severance payments to certain employees who agreed to allow the company to file a refund claim for them.
Sixth Circuit’s Analysis
The Internal Revenue Code imposes FICA tax on "wages," which it defines in Section 3121(b) as "all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash…." The Code does not expressly include or exclude severance payments from the definition of "wages" in Section 3121(b). As such, the Sixth Circuit looked to another section of the Code for guidance.
In Section 3402, the Code uses a definition of "wages" for purposes of income tax withholding that is nearly identical to the definition in Section 3121(b). However, Section 3402 also includes a subsection (o) entitled "Extension of withholding to certain payments other than wages," which provides that a supplemental unemployment compensation benefit payment (SUB payment) is treated "as if it were a payment of wages" subject to income tax withholding. Under Section 3402(o), a SUB payment is an amount paid to an employee that is:
- paid pursuant to an employer’s plan,
- because of an employee’s involuntary separation from employment,
- resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar condition, and
- included in the employee’s gross income.
The Sixth Circuit focused on Section 3402(o) and concluded that this language implies that Congress did not consider SUB payments to be "wages." Otherwise, subsection (o) would be unnecessary. Since the definitions of "wages" in Section 3121(b) and Section 3402 are nearly identical, the Sixth Circuit reasoned that if SUB payments are not "wages" for purposes of federal income tax withholding under Section 3402 (except for subsection (o)), then SUB payments also are not "wages" for purposes of FICA tax under Section 3121(b) which does not include a provision similar to subsection (o), nor address SUB payments at all.
Accordingly, under the Sixth Circuit decision, any severance payment that satisfies the above definition of "SUB payment" is not subject to FICA tax.
The Sixth Circuit’s decision is at odds with the 2008 decision of the Federal Circuit Court of Appeals in a case involving CSX Corp. In the CSX Corp. case, the Federal Circuit rejected the argument that the language used with respect to SUB payments in Section 3402(o) for purposes of income tax withholding implies that SUB payments are not "wages" for purposes of FICA tax under Section 3121(b).
Considering that the Sixth Circuit decision creates a "circuit split" and puts a large amount of revenue at risk, the Treasury Department is likely to appeal the decision to the U.S. Supreme Court. Alternatively, the Treasury Department may try to resolve the issue through regulations. In addition, Congress could resolve the issue with legislation.
What Employers Should Do
Employers within the Sixth Circuit should consider seeking refunds for FICA taxes that were paid with respect to severance payments that are SUB payments under the definition in Section 3402(o) (set forth above). Refund claims must be filed within the applicable statute of limitations for a tax year. The statute of limitations for FICA taxes paid in 2009 closes on April 15, 2013. Keep in mind that seeking a refund is more onerous than simply filing an IRS claim form. Specifically, the IRS requires that an employer seeking a refund of FICA taxes make reasonable efforts to recover a refund for employees as well. In general, this requires an employer to obtain an employee’s written consent to claim a FICA tax refund with respect to a payment made to the employee.
Given the uncertain future of the Sixth Circuit’s holding in the Quality Stores case, employers should exercise caution in relying on the case to stop payment and withholding of FICA tax for severance payments made in the future.