[authors: Marvin S. (Bucky) Swift, Jr. and Kevin J. Hogan]
In United States v. Quality Stores, Inc., et al., the United States Court of Appeals for the Sixth Circuit recently held that severance payments qualified as supplemental unemployment compensation benefit (SUB) payments and were not taxable as wages under the Federal Insurance Contributions Act (FICA). This decision is contrary to the IRS’s long-standing position that most employer-provided severance payments are subject to FICA withholding.
Quality Stores, an agricultural retailer, had closed a number of its stores and ultimately went into an involuntary Chapter 11 bankruptcy in 2001. Quality Stores made severance payments under both pre- and post-bankruptcy plans. The pre-bankruptcy severance plan based payments on job grade and management level in the organization and paid benefits over time on the normal payroll schedule. The post-bankruptcy severance plan was designed to encourage employees to stay with the company and provided lump-sum payments. Payments under both plans were not conditioned on receiving state unemployment compensation, nor were they attributable to any particular service.
Quality Stores reported the income on the employees’ W-2s, withheld federal income taxes and paid the employer and employee portions of FICA. Subsequently, Quality Stores filed for a refund of the FICA taxes claiming that the severance payments were SUB payments and not subject to FICA. The IRS did not respond to the refund claim and Quality Stores filed an adversary action in bankruptcy court in June 2005. The bankruptcy court and federal district court in Michigan agreed with Quality Stores and held that the payments were SUB payments and not subject to FICA withholding. The IRS appealed the case to the United States Court of Appeals for the Sixth Circuit.
Sixth Circuit Decision
To begin, the Sixth Circuit confirmed that SUB payments are not wages and are only treated as wages for purposes of federal income tax withholding. SUB payments are contingent on the employee’s termination of employment and fall outside the statutory meaning of service performed by an employee for an employer. However, the Internal Revenue Code only provides a definition of SUB pay in the context of federal income tax withholding and not FICA taxes. The court held that the definition of SUB pay contained in the federal income tax withholding statute should extend to FICA. Accordingly, because SUB payments are not wages pursuant to that definition, those payments are not subject to FICA. After extending the statutory definition of SUB pay and confirming the tax treatment of these payments, the court next considered whether the payments under the Quality Stores severance plans were SUB payments.
The IRS has historically determined whether severance payments qualify as SUB payments according to an eight-factor test set forth in its published rulings. Importantly, the IRS test requires severance payments to be linked to the employee receiving state unemployment compensation and to not be paid in a lump sum. Under the IRS test, the Quality Stores severance payments did not qualify as SUB payments because they were not tied to the employee receiving state unemployment compensation and the post-bankruptcy severance plan provided for lump sum payments. Nevertheless, the Sixth Circuit concluded that the IRS’s test, as set forth in its published rulings, was inconsistent with the statutory definition of SUB payments for federal income tax withholding purposes, which the court used for FICA tax purposes.
The Sixth Circuit divided the statutory definition of SUB payments into the following five requirements:
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; and
Included in the employee’s gross income.
Notably, the court did not require that the benefits be tied to receiving state unemployment compensation or prohibit lump sum payments, as the IRS required in its SUB pay test.
The Sixth Circuit held that all payments made by Quality Stores under both severance plans satisfied the five-part statutory test to qualify as SUB payments and, therefore, were not subject to FICA. Accordingly, Quality Stores was entitled to reimbursement from the IRS for the FICA taxes it remitted with respect to the payments under both severance plans.
The potential impact of the Quality Stores decision could be very substantial. If other Circuits adopt the Sixth Circuit’s position, employers may no longer have to withhold and pay FICA taxes on severance payments similar to those made by Quality Stores. In fact, many employers have already filed amended returns to recover FICA taxes already paid. However, the Quality Stores decision is contrary to the IRS’s current and long-established position; and it is likely that the IRS will continue to defend this position in other Circuits. It must also be noted that Quality Stores is only the law in the Sixth Circuit and the outcome in other circuits is uncertain, which has led some observers to comment that this issue is ripe for Supreme Court review. The Department of Justice has filed a petition for rehearing en banc, which will delay a Supreme Court review until the Sixth Circuit decides to rehear the case or denies the petition.
Ultimately, it is unclear what effect the Quality Stores decision will have on employers, particularly those outside the Sixth Circuit. Based on the decision, employers in the Sixth Circuit should consider filing for a refund of FICA taxes remitted with respect to severance payments for all years not barred by the statute of limitations. Employers in other Circuits should consider taking action to preserve their rights to file refund claims and refund suits in anticipation of a potential shift in the way severance payments are treated regarding FICA taxes.
United States v. Quality Stores, Inc., et al., 2012 U.S. App. LEXIS 18820 (6th Cir. 2012). [back]
 I.R.C. § 3402(o) is titled “Extension of withholding to certain payments other than wages” and extends the federal income tax withholding obligation to SUB payments. [back]
 I.R.C. § 3402(o)(2)(A). [back]
 FICA is only imposed on “wages.” See I.R.C. §§ 3101, 3111, and 3121(a). [back]
 Rev. Rul. 56-249, 1956-1 C.B. 488; Rev. Rul. 90-72, 1990-2 C.B. 211. [back]
 I.R.C. § 3402(o)(2)(A). [back]
 Filing a refund claim is a prerequisite to a refund suit in federal court. See I.R.C. § 7422(a). [back]