A few weeks ago, the Sixth Circuit affirmed the Western District Court of Michigan’s holding in U.S. v. Quality Stores Inc., 424 B.R. 237 (W.D. Mich. 2010), that severance payments made to employees pursuant to an involuntary reduction in force were not “wages” for Federal Insurance Contribution Act (“FICA”) tax purposes. U.S. v. Quality Stores Inc., No. 10-1563 (6th Cir. 2012). The Sixth Circuit’s decision creates a circuit court split with the Federal Circuit and its 2008 decision in CSX Corporation v. United States, 518 F.3d 1328 (Fed. Cir. 2008).
The taxpayer, Quality Stores, was the largest agricultural implement retailer in the United States. Pursuant to a bankruptcy reorganization, Quality Stores closed all of its stores and distribution centers and terminated the employment of all of its employees. Quality Stores made severance payments to the employees that were terminated involuntarily. Severance was based on job grade and management level in the organization. Because the severance payments constituted gross income to the employees for federal income tax purposes, Quality Stores reported the payments as wages on W-2 forms and withheld federal income tax. Quality Stores also paid the employer’s share of FICA tax and withheld each employee’s share of FICA tax. Quality Stores, however, argued that the severance payments were not “wages” but instead were “supplemental unemployment compensation benefits” (“SUB payments”) pursuant to Internal Revenue Code section 3402(o)(2), and therefore were not taxable under FICA.
The Sixth Circuit agreed with Quality Stores. The court noted that a SUB payment consists of five separate elements: (1) an amount paid to an employee; (2) pursuant to an employer’s plan; (3) because of an employee’s involuntary separation from employment, whether temporary or permanent; (4) resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions; and (5) included in the employee’s gross income. The payments made by Quality Stores qualified as SUB payments because they satisfied all five of these statutory requirements.
Next, the circuit court held that SUB payments were not wage payments under the income tax withholding statute. Even though section 3402(o)(2) covers income tax withholding, not FICA taxes, the Sixth Circuit concluded that any statutory exemption from “wages” like that provided for in these involuntary severance benefits must be deemed to extend to FICA taxes as well, unless the IRS provides a different rule by regulation.
In so holding, the court rejected the IRS’s arguments that Quality Store’s severance payments were not true SUB payments. The IRS claimed that, in order to qualify as SUB payments, the severance payments had to be specifically linked to a former employee’s receipt of unemployment benefits – a position previously articulated in IRS revenue rulings and adopted by the Federal Circuit in CSX Corp. v. U.S. The Sixth Circuit found, however, that nothing in the statute governing FICA taxation required the link between severance payments and unemployment benefits advanced by the IRS, and opted to “resolve the tension between statutory enactments and the IRS revenue rulings in favor of the expressed will of the legislature.”
The United States has 90 days to seek review of the decision by the United States Supreme Court. Given the split among the Courts of Appeals, the significant financial impact this decision could have on claims for refund of FICA taxes and the uncertain state of the law, the Supreme Court may decide that the issue is ripe for review.