Today’s job market is struggling and, unfortunately, layoffs are still common place. Often this downsizing of a company’s workforce results in severance payments to departing workers. A new ruling from the Sixth Circuit on Friday September 7, 2012 could give companies who made such payments and the discharged workers who received them an opportunity to recover Federal Insurance Contributions Act (“FICA”) taxes paid on the severance payments provided refund claims are not barred by the statute of limitations. Future severance payments could also escape FICA taxes under the authority of this new decision.
The Court of Appeals for the Sixth Circuit, affirming a district court, has held that severance payments are not subject to FICA taxes in U.S. v. Quality Stores, Inc., (CA 6 9/7/2012) 110 AFTR 2d (“Quality Stores”), allowing a refund of over $1 million in employer and employee FICA taxes paid on the severance payments.
This ruling by the Sixth Circuit is contrary to a prior ruling in the Fifth Circuit in CSX Corporation v. United States, 518 F.3d 1328 (5th Cir., March 2008) (“CSX”). In light of these conflicting decisions and given the potential amount of revenue involved, IRS may appeal the Quality Stores case to the Supreme Court. In fact, Congress could even step in to clarify the statute, though we don’t advise holding your breath until this happens.
As a result of the contrary decisions, and since we cannot tell the future, taxpayers should consider filing protective refund claims in order to protect their claim for refund from being barred by the statute of limitations. The date of expiration for the statute of limitations will vary based on each taxpayer and when severance payments were made/received (since payroll returns are filed quarterly), thus it is imperative that all taxpayers who have made/received severance payments anytime during the past three years look into this issue immediately. For example, the statute of limitations will expire for severance payments made/received during the third quarter of 2009 in less than two months, on October 31, 2012.
For higher income workers who met the social security limit prior to their departure, only the Medicare portion of the FICA tax is at issue. However, if the separation date for a worker was early in the calendar year, the Social Security portion of the FICA tax may also be on the table.
Individuals should contact their former employers to inquire if that employer is going to file with the IRS on their behalf before filing individually (see below regarding Form 843). If an individual’s former employer cannot be reached, or is no longer in business, it may be up to the individual to file their own protective refund claim.
This is a big deal. Seriously! A lot of money (i.e. much needed liquidity, these are companies that were downsizing remember) could be at stake for many employers and individual taxpayers. Contact us if you need help determining if you should file a protective refund claim.
Some People Like to Understand the Details…So Here They Are…
The Sixth Circuit determined that the severance payments at issue in the Quality Stores case qualified as supplemental unemployment compensation benefits (“SUBs”) under Internal Revenue Code (“IRC”) Section 3402(o), which treats certain non-wage payments as if they were wages for income tax withholding purposes. The Court said that this showed that Congress also didn't regard SUB payments as wages for FICA purposes.
“Wages” For Income Tax Withholding & FICA Tax
The income-tax withholding provisions of the IRC generally define “wages” in substantially the same way as it does for FICA purposes. In general, the term means all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash.
In Rowan Companies Inc v. U.S., (1981, S Ct) 48 AFTR 2d 81-5115, 452 US 247 (“Rowan”), the Supreme Court declared that Congress intended a uniform definition of “wages” for purposes of FICA, FUTA, and income tax withholding. IRC Section 3121(a) was subsequently amended to carry a so-called “de-coupling” rule, namely that nothing in the income tax withholding Regulations which provides for an exclusion from wages for withholding purposes “shall be construed to require a similar exclusion from” wages for FICA purposes.
Supplemental Unemployment Compensation Benefits
Under the heading “Extension of withholding to certain payments other than wages,” IRC Section 3402(o) provides that three enumerated types of payments, including “any supplemental unemployment compensation benefit paid to an individual” are to be treated “as if” it were a payment of wages for income tax withholding purposes. Under IRC Section 3402(o)(2), the term SUBs is defined as “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 plan of operation or other similar conditions ....” IRC Section 3121(a) excludes from FICA wages two of the three types of payments named in IRC Section 3402(o) (annuity payments and sick pay), but it does not exclude SUBs.
In Revenue Ruling 90-72, the IRS asserted that “the definition of SUB pay under IRC Section 3402(o) is not applicable for FICA or FUTA purposes. For FICA or FUTA purposes, SUB pay is defined solely through a series of administrative pronouncements published by the Service.” This ruling, which relies on a position first articulated in a previous Revenue Ruling, says that to be exempt from FICA, SUBs must meet a number of unique conditions such as: weekly benefits must not be payable based on state unemployment benefits, or other compensation allowable under state laws. Additionally, the amount of straight-time weekly pay and the duration of SUB benefits must be affected by the SUB fund level and the employee's seniority. And, lump-sum benefits aren't excluded from FICA according to Revenue Ruling 90-72.
In 2002, the Court of Federal Claims held that severance pay was not subject to FICA, but then in 2008, the Court of Appeals for the Federal Fifth Circuit reversed and held that the severance pay involved in the taxpayer's various downsizing programs was subject to FICA. This was the CSX case or the “contrary” case mentioned above.
Facts Relating to the Quality Stores Case
Quality Stores, Inc. (“Quality”) went into bankruptcy. During the period preceding the bankruptcy cases, Quality closed many of its locations and also terminated approximately 75 employees at its corporate office. On October 20, 2001, an involuntary chapter 11 bankruptcy petition was filed against Quality. After the petition date, Quality closed its remaining stores and distribution centers and terminated all of its remaining employees.
Quality made severance payments to employees who were terminated before and after the petition date. The payments were made under severance plans and because of the employees' involuntary separation from employment, which resulted directly from a reduction in force or the discontinuance of a plant or operation. The payments were not connected to the receipt of state unemployment compensation and were not attributable to the rendering of any particular employment service. The severance payments made prior to the petition date were paid on a weekly or semi-weekly basis during Quality's normal payroll periods and those made after the petition date were paid in a lump sum. None of the payments were connected to the receipt of state unemployment compensation.
All of the severance payments were included in the employees' gross income, and Quality reported the severance payments as wages on the W-2 forms issued to its employees. Quality withheld federal income tax and the employees' share of FICA tax from the severance payments, and also paid the employer's share of FICA tax on the severance payments.
In 2002, Quality filed refund claims with IRS for overpaid FICA, plus interest, on the severance payments. The claims included the employer's share of FICA, and the employees' share of FICA for those employees who consented to permit Quality to make the refund request for them.
Note: Employees can individually request a refund for their share of FICA taxes withheld with Form 843 if their employer will not request a refund and adjust the over collection.
When IRS did not allow or deny the refund claims, Quality Stores filed an adversary action in the bankruptcy court, which concluded that the severance payments were not wages for FICA purposes. The district court affirmed the bankruptcy court.
Sixth Circuit Says Severance Payments Were SUB Payments Exempt from FICA
The Sixth Circuit noted that the FICA statute does not expressly include or exclude SUB payments from wages. However, under IRC Section 3402(o), a SUB payment meeting the conditions of IRC Section 3402(o)(2)(A) is treated as wages for purposes of Federal income tax withholding. All payments Quality made to its former employees satisfied the five-part statutory test to qualify as SUB payments, as discussed above.
The Sixth Circuit stressed that Congress expressly provided in IRC Section 3402(o)(1) that any payment made to an employee that meets the statutory definition of a SUB payment “shall be treated as if it were a payment of wages by an employer to an employee for a payroll period.” This implied that Congress did not consider SUB payments to be “wages” but allowed their treatment as wages to facilitate federal income tax withholding for taxpayers. The Court said that the title of IRC Section 3402(o), “Extension of withholding to certain payments other than wages,” supports its conclusion, as does the legislative history. (emphasis added)
The Sixth Circuit said that under Rowan, the definition of wages should be the same both for income tax withholding and FICA purposes. Thus, since Congress didn't regard SUB payments as wages for income tax withholding, but treated them only as if the payment were wages for purposes of federal income tax withholding, it could not have regarded them as wages for FICA purposes. The Court rejected IRS's argument that the decoupling amendment overrode Rowan.
IRS cited numerous Revenue Rulings in support of its view that severance payments are subject to FICA taxes. However, the Sixth Circuit rejected the Rulings because it found them to be inconsistent with the statue and legislative history.
The Sixth Circuit court acknowledged in its opinion that this issue of statutory construction is “complex” and that the correct resolution is “far from obvious.” It further went on to say that "while the Supreme Court may ultimately provide us with the correct resolution,” it is “only Congress [that] can clarify the statutes concerning the imposition of FICA tax."
The Sixth Circuit’s ruling in the Quality Stores case has the potential to have great impact. In fact, this ruling could be a windfall for companies who are in desperate need of liquidity. While the funds won’t be immediately available, as the IRS will likely appeal the Quality Stores case to the Supreme Court, protecting the right to claim a refund is important and must be done timely. So don’t waste any time! Click the button below so the Tax Warriors can help you determine if a protective refund claim is in your or your company’s best interest.