The Sixth Circuit: Severance, NOT Subject to FICA.
Last month, the Sixth Circuit affirmed a Michigan Bankruptcy Court and District Court order approving a corporate taxpayer's request for refund of FICA (Federal Insurance Contribution Act) taxes on severance payments to terminating employees. In re Quality Stores, Inc., 693 F.3d 605 (6th Cir. 2012). As part of a company-wide reduction in force, Quality Stores paid severance to terminating employees and subsequently collected and remitted the total FICA tax to the IRS, largely in an abundance of caution. Quality Stores, however, disagreed with having to withhold and remit FICA taxes on these severance amounts; it thus filed an IRS refund claim, seeking to recover $1 million in FICA tax paid (for itself and over 1,800 former employees).
In its refund claim, Quality Stores asserted that the severance payments were not “wages” for FICA purposes, but instead, it had 26 U.S.C. § 3402 supplemental unemployment compensation benefits ("SUB pay"), and that such pay was not taxable under FICA. Quality Stores, 693 F.3d at 610. The IRS rejected Quality Stores' refund request and contended that the SUB pay must be conditioned upon the employees' receipt of other unemployment benefits in order to be exempt from FICA taxes. The IRS further contended that the SUBs must be paid in installments, rather than in a lump sum, as was the case with Quality Stores.
Ultimately agreeing with Quality Stores, the Sixth Circuit rejected the IRS's argument as an imposition of additional limitations that neither law nor regulation required. The court found that the company made SUB payments to assure workers of unemployment security and to reward employees for tenure, rather than deferred compensation for services rendered. Consequently, the court determined that the SUB payments were not "wages" for purposes of FICA, even though the payments were "wages" for federal income tax withholding. The Sixth Circuit’s decision creates a split, as the Federal Circuit has approved the IRS's position that a taxpayer that pays SUB pay is subject to FICA tax. CSX Corp. v. United States, 518 F.3d 1328 ( Fed. Cir. 2008).
Tax Refund (or Savings) for Potential for Corporate Taxpayers with a Presence in Michigan, Ohio, Tennessee, and Kentucky.
Sixth Circuit Offers Savings or Refund Potential.
For now, corporate taxpayers should still comply with FICA on SUB pay until the courts (likely the United States Supreme Court) or Congress settles this matter. However, any such corporate taxpayer who downsized and paid severance (and FICA) should consider protecting its rights by filing a protective refund claim with the IRS before the 3-year period of limitation expires if the Quality Storesdecision continues to stand (but see below regarding the Department of Justice). The right to file a refund claim for the 2009 tax year expires April 15, 2013, for employers who timely filed their quarterly Forms 941. Though the Sixth Circuit's opinion applies principally to employers in Michigan, Ohio, Tennessee, and Kentucky, it could have further reaching implications for those corporate taxpayers with headquarters or mere operations in those states (where employees from those operations are terminated, with severance). This might create a venue or forum opportunity taxpayers in similar severance situations to challenge an IRS rejection. A purportedly SUB payment, with an ability to have a case appealable to the Sixth Circuit (where there is now taxpayer-favored precedent), could be the difference in millions of dollars in potential savings for employers and employees.
DOJ Involvement and/or Supreme Court Review.
On October 18, the Justice Department filed a petition for rehearing en banc in the Sixth Circuit regarding Quality Stores. Such a rehearing, exceedingly uncommon under normal circumstances, asks the entire Court of Appeals (rather than the three sitting judges for any one argument) to reconsider. The Justice Department (acting on behalf of the IRS in this instance) filed the motion for two strategic purposes: first, if the Sixth Circuit agrees to rehear, there is a chance the court will reverse itself and favor the government’s position, treating the severance as “wages” for FICA purposes; and second, even if the court declines to rehear or affirms its earlier decision, this accords the government time to file a petition for certiorari to the Supreme Court.