Sixth Circuit Decision Offers FICA Tax Refund Opportunities for Severance Pay

Any employer that implemented reductions in force or layoffs after 2008 should consider filing refund claims for the Federal Insurance Contributions Act (FICA) taxes paid on severance benefits based on a recent Sixth Circuit Court of Appeals decision. In United States v. Quality Stores, Inc., No. 10-1563 (September 7, 2012), the Sixth Circuit held that severance payments paid to employees pursuant to an involuntary reduction in force were not “wages” for FICA tax purposes.

Quality Stores, a debtor in bankruptcy, closed a number of stores and distribution centers and through its severance plans paid periodic and lump sum severance to employees on account of the involuntary separation resulting directly from a reduction in force or the discontinuance of a plant or operation. The payments were not conditioned on the receipt of state unemployment compensation and did not relate to the rendering of any particular employment service. Quality Stores reported the severance payments as wages on W-2 forms and withheld federal income tax and employment taxes from them.

Internal Revenue Service (IRS) rulings at that time exempted only certain involuntary severance payments from FICA taxes, provided that those payments satisfied the IRS’s administrative definition of supplemental unemployment benefits compensation (“SUB Pay” or “Sub payments”). The IRS required, among other things, conditioning receipt of severance on an employee’s receipt of unemployment compensation benefits and payment of the benefits in installments rather than a lump sum. According to the IRS, FICA applied to all other severance payments.

Quality Stores challenged the IRS’s position that traditional severance payments are subject to FICA and subsequently filed refund claims to recover more than one million dollars in FICA taxes. Quality Stores argued that FICA does not apply to any severance satisfying the broader statutory definition of SUB Pay provided in section 3402(o) of the Internal Revenue Code.

The Sixth Circuit agreed with Quality Stores, concluding that severance that satisfies the statutory definition of SUB Pay is exempt from wages for both income tax and FICA tax purposes. Significantly, those requirements do not require that SUB payments be tied to the employee’s receipt of unemployment compensation benefits and do not distinguish between periodic or lump sum payments. This decision represents a substantial expansion of the types of severance that are exempt from FICA.

The Quality Stores decision creates a conflict in the circuit courts. As such, the ultimate resolution of this issue is several years away. The federal government has not announced whether it will appeal the Quality Stores decision to the U.S. Supreme Court, but it likely will. It also is possible that the decision could prompt the development of a coordinated settlement program. We will monitor and report to you any future developments in this area.

FICA Refund Opportunity
For many employers this could represent a significant FICA-tax refund opportunity. The amount at stake is considerably higher than the actual taxes because interest is paid on successful refund claims.

For a more detailed analysis of the Quality Stores decision, click here.