Any employer that implemented reductions in force or layoffs after 2008 should consider filing refund claims for the Federal Insurance Contribution 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.

Factual Background

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.

Legal Analysis

The Sixth Circuit agreed with Quality Stores, concluding that severance that meets the following five requirements of section 3402(o) is exempt from FICA:

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 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.

Significantly, the section 3402(o) 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. In effect, the Sixth Circuit’s ruling rejects the additional limitations imposed by the IRS and represents a substantial expansion of the types of severance that are exempt from FICA.

The Sixth Circuit rejected the government’s arguments and IRS rulings on SUB Pay as inconsistent with congressional intent. The Sixth Circuit reasoned that severance that satisfies the statutory definition of SUB Pay provided in section 3402(o) is SUB Pay and that SUB Pay is exempt from wages for both income tax and FICA tax purposes. (The court’s decision did not alter Quality Stores’ obligation to withhold federal income taxes on the payment of SUB Pay or change the fact that SUB Pay is includible in an employee’s gross income.) The court relied on Rowan Cos. v. United States, 452 U.S. 247 (1981), in its conclusion that the statutory term “wages” should be interpreted consistently in the statutes governing FICA and federal income tax. The Sixth Circuit reasoned that because Congress treated SUB payments as if they were “wages” for federal income tax withholding purposes, the same definition must apply under FICA. The Sixth Circuit concluded that because SUB Pay is not wages for federal income tax purposes, SUB Pay also is not wages for FICA purposes.

The Quality Stores decision creates a conflict in the circuit courts. In CSX Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008), the Federal Circuit Court of Appeals held that severance payments at issue were not SUB Pay and were wages for FICA taxes because the payments did not satisfy the IRS’s more restrictive definition of SUB Pay (described above).

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.

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.

Employers residing within the jurisdiction of the Sixth Circuit (i.e., Kentucky, Michigan, Ohio, and Tennessee) that paid involuntary severance payments to employees after 2008 should file FICA-tax refund claims. Employers that are anticipating providing severance payments that qualify as SUB Pay in 2012 and future years should consult with their tax advisors to determine whether to pay and withhold FICA taxes on those benefits.

Employers residing outside the jurisdiction of the Sixth Circuit should continue to withhold FICA taxes and, if not facing imminent statute of limitations issues, should consider carefully their procedural options (including filing protective refund claims for years not closed by the statute of limitations (2009-2012), participating in a coordinated settlement with the IRS, and/or litigation).

Attorneys in Ogletree Deakins’ Employee Benefits group routinely advise on employment tax matters (including severance pay and SUB Pay), have filed and advised on Quality Stores-type FICA-tax refund claims, have assisted clients in the IRS appeals process following refund denials, have designed SUB Pay plans and SUB Pay trusts that comply with the IRS’s revenue rulings on SUB Pay, and have advised on the benefits thereof.

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