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Sixth Circuit rules severance pay not subject to FICA tax

October 1st, 2012  |  Lorene Park

The Sixth Circuit has ruled that severance payments to employees whose employment ended involuntarily due to business cessation constituted supplemental unemployment compensation benefits (SUB payments) not taxable as wages under the Federal Insurance Contributions Act (FICA) (United States of America v Quality Stores, Inc, September 7, 2012, Stranch, J). The employer (and employees who agreed to be represented by the company) were thus entitled to a refund of $1,000,125 paid in FICA taxes. This decision stands in stark contrast to both IRS revenue rulings and a 2008 decision from the Federal Circuit, CSX Corp v. United States. Unless or until the issue is resolved by the Supreme Court or an act of Congress, the Quality Stores decision will have significant implications for employers who have had recent layoffs or are considering them.

Quality Stores severance benefits.

The agricultural-specialty retailer was subject to involuntary bankruptcy in 2001, eventually closing all stores and terminating all employees. The company paid severance under two plans, and the payments were not tied to state unemployment benefits or to providing any particular services. Quality Stores reported the severance as wages and withheld federal income tax. It also paid FICA tax, but disagreed with the IRS position that the payments were wages under FICA. The company argued they were SUB payments that were not taxable under FICA and sought a $1,000,125 refund ($571,127 for the employer and $428,998 for the employees). When that was denied, Quality Stores filed an adversary action. The district court granted judgment in Quality Stores’ favor and the government appealed.

Sixth Circuit: Quality Stores’ SUB payments were not “wages” subject to FICA.

On appeal, the issue was whether the severance payments were SUB payments and, if so, whether they were “wages” taxable under FICA. As an initial matter, the Sixth Circuit discussed the history of SUB payments, the purpose of which was to provide employment security regardless of hours worked rather than to compensate for work performed. SUB payments “are contingent on the employee’s being thrown out of work” and were analogous to severance. In the court’s view, the ultimate question of “[w]hether SUB payments are ‘wages’ under FICA is a complex question because the FICA statute does not expressly include or exclude SUB payments, nor do the Treasury regulations promulgated under FICA address the subject.”

For guidance, the court looked to nearly identical provisions in the Internal Revenue Code (IRC) on income tax withholding and determined that the severance payments by Quality Stores were SUB payments. Under IRC Sec. 3402, “wages” are remuneration “for services performed.” In Sec. 3402(o)(2)(A), which refers to withholding for payments “other than wages,” SUB payments are defined to include: (1) an amount paid to an employee; (2) pursuant to an employer’s plan; (3) because of an employee’s involuntary termination; (4) resulting from a reduction in force or discontinuance of operations; and (5) included in the employee’s gross income. Here, the severance payments satisfied that test. The parties stipulated they were made to employees under severance plans because of terminations due to a discontinuation of operations. Although the stipulation did not refer to gross income, the payments were included in the employees’ gross incomes. Thus, drawing from the statute concerning federal income tax withholding, the court ruled that the severance benefits were SUB payments.

Continuing its analysis, the Sixth Circuit concluded that the SUB payments were not “wages” subject to FICA tax. The court again relied on statutory text and history. For purposes of income tax withholding, Congress characterized SUB payments as non-wages and enacted Sec. 3402(o) simply to extend withholding to the non-wage payments. The Sixth Circuit reasoned that if SUB payments are not wages but only treated as wages for purposes of federal income tax, then SUB payments are also not wages under FICA. In support of this analytical leap, the court pointed out that the U.S. Supreme Court in Rowan Cos v United States instructed that the statutory term “wages” should be interpreted consistently in the statutes governing FICA tax and federal income tax.

Going forward.

The effect of Quality Stores going forward is unclear considering that the government may appeal and not all severance pay will be covered by the decision. Outside of the Sixth Circuit, the IRS will likely maintain the position that SUB payments are subject to FICA tax. The Supreme Court may resolve the conflict under existing law or Congress could clarify statutes governing the imposition of FICA tax on SUB payments. Meanwhile, outside the Sixth Circuit, continue withholding FICA taxes on severance payments to employees who are involuntarily terminated and which do not fall within an IRS exemption. Within the Sixth Circuit, consult a tax advisor and watch for a likely appeal to the Supreme Court. With respect to FICA taxes already paid on severance benefits that might fall within the Quality Stores fact pattern, consider filing for a refund or preserving the opportunity to do so by filing a protective claim. Be aware of the administrative costs in pursuing refunds (e.g., refund procedures require employers to notify the employees who were paid severance). Above all, keep a close eye on this developing area of law.

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