On September 7, 2012, a unanimous panel of the U.S. Court of Appeals for the Sixth Circuit held in United States v. Quality Stores, Inc., 110 AFTR 2d ¶2012-5253 (CA6 9/7/12) that payments which were made pursuant to two separate employer severance plans, to employees upon their involuntary termination of employment because the employer was terminating operations, constituted supplemental unemployment compensation benefits (“SUB Payments”) that are not taxable as wages under the Federal Insurance Contribution Act (“FICA”). This decision creates a split among the federal courts of appeal because in 2008 the U.S. Court of Appeals for the Federal Circuit had determined that severance payments generally were not SUB Payments and were wages subject to FICA taxes. See CSX Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008).
Over the past several years, many companies have implemented involuntary reduction-in-force programs due to downsizing, plant closings or other restructurings. For many employers that had followed the dispute about whether severance payments were subject to FICA taxes, the decision in CSX Corp. signaled that the battle was lost, and since 2008 they have no longer filed protective refund claims relating to FICA taxes paid under these reduction-in-force programs. However, based on the recent Quality Stores decisions, companies should seek advice from counsel to reevaluate whether it is appropriate to file protective refund claims for open tax years.
IRS Position regarding SUB Payments
To better understand the split between the decisions by the Sixth Circuit and the Federal Circuit, it is important to first understand the IRS’s current position regarding which SUB Payments are exempt from FICA. Based on certain IRS Revenue Rulings from 1956 to 1990, IRS guidance created a basic distinction between “dismissal pay” that is subject to FICA taxes and SUB Payments that are not subject to FICA taxes. In particular, under Revenue Ruling 90-72, the following criteria must be satisfied for a payment to be a SUB Payment that is exempt from FICA taxes:
- The benefits must be paid only to unemployed former employees who had been laid off by the employer.
- The amount of payments must be linked to receipt of state unemployment benefits.
- The duration of the benefits is affected by the employee’s seniority.
- The benefits are not paid based on the rendering of particular services.
- The right to the benefits does not accrue until a prescribed period after termination of employment has lapsed.
- Payments cannot be received in a lump sum.
Quality Stores’ Claim That Severance Payments Were Not FICA Wages
Quality Stores was subject to an involuntary Chapter 11 bankruptcy petition, and during the bankruptcy proceedings established separate pre-petition and post-petition severance plans and made severance payments under them to employees who had an involuntary termination of employment due to the company ceasing operations. Under both plans, the severance payments were not tied to the receipt of state unemployment compensation and were not attributable to the provision of any particular services by the employees. In addition, neither plan required employees to prove they were unemployed in order to receive severance payments, and payments under the post petition plan were paid in lump sum payments. Quality Stores remitted to the IRS all applicable FICA taxes on the applicable severance payments.
Quality Stores took the position that payments under the severance plans were not FICA wages, but instead constituted SUB Payments that were not taxable under FICA. For that reason, Quality Stores filed a refund claim with the IRS for $1,000,125.00 in overpaid FICA. The IRS took a no action position and neither denied nor allowed the refund claim. Quality Stores then filed an adversary action in bankruptcy court seeking a refund of the FICA taxes. The bankruptcy court determined that the severance payments were SUB Payments that were not subject to FICA taxes and the federal district court for the Western District of Michigan affirmed.
Sixth Circuit Decision Supreme Court’s Coffy Decision Is Controlling
In affirming the district court’s decision, the Sixth Circuit relied on the Supreme Court’s decision in Coffy v. Republic Steel Corp., 447 U.S. 191, 205 (1980), in which the Supreme Court had stated that SUB Payments are not compensation for worked performed, but compensation for the rights and benefits forfeited by the employee in giving up his or her job. The Sixth Circuit recognized that in Social Security Board. v. Nierotko, 327 U.S. 358, 365-66 (1946)), the Supreme Court had interpreted broadly the remuneration that would constitute FICA wages to include any compensation that is based on the employee-employer relationship. However, the Sixth Circuit found that the Supreme Court’s instruction in Coffy was directly on point and that the Nierotko decision was not the controlling authority on this issue.
Congressional Intent That SUB Payments Are Not Subject to FICA Taxes
The Sixth Circuit noted that neither the FICA statute nor any Treasury regulations expressly address whether SUB Payments are subject to FICA taxes. For that reason, the Sixth Circuit decided the statute was ambiguous, and it should look to whether Congress had expressed any intent about whether SUB Payments were FICA wages. First, the Sixth Circuit noted that for purposes of federal income tax withholding under Section 3402(a) of the Internal Revenue Code of 1986 (the “Code”) and FICA taxation under Section 3121(a) of the Code, Congress has adopted nearly identical definitions of “wages.” Second, the Sixth Circuit found that the title, text and legislative history of Code section 3402(o) demonstrated that Congress did not believe that the definition of wages for purposes of income tax withholding covered SUB Payments. In support of its decision, the Sixth Circuit cited the Supreme Court’s decision in Rowan Cos. v. U.S., 452 U.S. 247, 257 (1981), in which the Supreme Court concluded that Congress had intended the term “wages” in those two statutes to have the same meaning for purposes of FICA and income tax withholding. The Sixth Circuit reasoned that if the term “wages” for purposes of FICA and income tax withholding had the same meaning then, by implication, because the definition for purposes of income tax withholding did not include SUB Payments, the definition for purposes of FICA wages also did not include SUB Payments.
Quality Stores Severance Payments Were SUB Payments Exempt from FICA Taxes
Parsing the statutory definition of SUB Payments in Code section 3402(o), the Sixth Circuit found that SUB Payments have five elements. A SUB Payment must be:
- An amount paid to an employee
- Pursuant to an employer’s plan
- Because of an employee’s involuntary separation from employment, whether temporary or permanent
- Resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions
- Included in the employee’s gross income
Finding that the payments made by Quality Stores under the company’s two severance plans had all five of these elements, the Sixth Circuit determined that the severance payments constituted SUB Payments that were not subject to FICA taxes.
IRS Revenue Rulings Do Not Take Congressional Intent Fully into Account
The Sixth Circuit recognized that the IRS has issued contrary revenue rulings stating that SUB Payments, for purposes of FICA taxation, are not determined by the definition under Code section 3402(o), but instead solely based on IRS revenue rulings. However, the Sixth Circuit found that those revenue rulings did not take congressional intent fully into account and, therefore, the Sixth Circuit would not defer to the IRS’s definition of SUB Payments for purposes of FICA taxes.
One thing both the Sixth Circuit and Federal Circuit did agree on is “that this issue of statutory construction is complex and that the correct resolution of the issue is far from obvious.” Based on the government’s longstanding position that dismissal pay is not exempt from FICA, and based on the amount of tax revenue that would be involved in losing on this issue, the government will probably seek en banc review of the Sixth Circuit’s Quality Stores decision. If that is not successful, because there is a split among the circuit courts, the government could also seek certiorari from the Supreme Court. In other words, this issue may not be resolved for some time. In the meantime, what should employers do with respect to paying FICA taxes on severance payments that do not meet the definition of a SUB Payment under Revenue Ruling 90-72?
- Continue to withhold and pay FICA taxes on severance payments even if the payments otherwise meet the requirements of SUB Payments under Code section 3402(o).
- Consider filing a protective refund claim for any FICA taxes paid in the 2009 calendar year on severance payments that otherwise would have meet the requirements of SUB Payments under Code section 3402(o). For severance payments made in the 2009 calendar year, this refund claim can generally still be filed until April 15, 2013.
If you have any questions regarding this article, please contract Marc Fosse at 415-277-8045.