Federal Appeals Court Holds That Supplemental Unemployment Compensation Benefits Are Not ‘Wages’ Subject To FICA Taxation, Creating Circuit Split

by Pepper Hamilton LLP


In an important recent decision, United States v. Quality Stores, Inc., et al., Case No. 01-1563, 2012 U.S. App. LEXIS 18820 (6th Cir. Sept. 7, 2012), the U.S. Court of Appeals for the Sixth Circuit held that supplemental unemployment compensation benefits (SUB payments) paid by a bankrupt company to its former employees were not wages subject to taxation under the Federal Insurance Contributions Act (FICA). Accordingly, the employer and its former employees were entitled to refunds of amounts paid to the Internal Revenue Service (IRS) on account of FICA taxes from severance payments that had been made after the employer filed for bankruptcy. The Sixth Circuit declined to follow a contrary 2008 decision on the issue of the Federal Circuit, CSX Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008), the only other court of appeals decision to address the issue. The refund claim at issue in Quality Stores totals approximately $1 million (plus interest); it is estimated that similar pending refund claims total over $4 million.

A reduction in federal tax liability is obviously beneficial to both employer and employee taxpayers. The Quality Stores decision could be especially beneficial to lower wage employees for whom FICA taxes constitute a major portion of their federal tax liability. Elimination of FICA tax liability would also increase the disposable income available to employees already suffering reduced earning prospects as a result of being laid off.

From the employer standpoint, the reduced FICA tax liability would free up money for deployment elsewhere in the enterprise at a time when funds may be tight. Employers who made severance payments to involuntarily terminated employees during the last few years could be affected by the decision. Thousands of companies are believed to have filed protective refund requests totaling $4 billion or more. Taxpayers should be aware of both a three-year statute of limitations to file a refund claim and a two-year statute of limitations for bringing a lawsuit after the denial of a refund request. It appears that many taxpayers have filed refund requests within the statute of limitations period to ensure that such requests were timely filed. It is believed that the IRS has been inundated with refund claims and, therefore, may not have processed the claims and communicated with taxpayers about the status of such claims in an orderly fashion. As a result, some taxpayers may be unaware that their refund requests have been denied because they may not have received notice of the denial. In such a case, the taxpayer may be unaware that the two-year period is running. Where lawsuits have been filed, the government reportedly has moved to stay the action pending the outcome of the Quality Stores litigation.

Quality Stores not only created a conflict among the federal courts of appeal on the applicability of FICA taxes to SUB payments, but it also raised a number of other important issues, including the level of deference to be afforded to IRS revenue rulings; the continued validity of the Supreme Court’s decision in Rowan; Cos v. United States; the impact of the so-called “decoupling amendment” (discussed below) on Rowan; and the Treasury’s ability to change the treatment of SUB payments under FICA through Treasury regulations.


Quality Stores, Inc. was the largest agriculture-specialty retailer in the country. In October 2001, Quality Stores and its affiliates filed Chapter 11 petitions, closed all of its stores and distribution centers, and terminated all of its employees. In addition, Quality Stores made severance payments to those employees whose employment was involuntarily terminated pursuant to severance plans that did not tie the payments to the receipt of state unemployment compensation, nor were the payments attributable to the provision of any particular services by the employees.

Because the severance payments constituted gross income to the employees for federal income tax purposes, under a special statutory provision, Quality Stores reported the payments as wages on W-2 forms and withheld federal income tax. Quality Stores also paid the employer’s share of FICA tax and withheld each employee’s share of FICA tax. The IRS contended that most SUB payments constitute wages subject to FICA tax, except for SUB payments that satisfy an eight-factor test established in certain IRS revenue rulings—including a requirement that the payments be tied to the receipt of state unemployment compensation benefits. Although Quality Stores collected and paid the FICA tax, it did not agree with the IRS that the severance payments constituted wages for FICA purposes. Quality Stores took the position that the severance payments were not wages subject to FICA tax.

Therefore, in September 2002, Quality Stores timely filed with the IRS refund claims on behalf of itself and certain of the former employees seeking the refund of all of the amounts paid for FICA tax, totaling approximately $1 million. After the IRS failed to allow or deny the refund claim, Quality Stores commenced an adversary proceeding in the bankruptcy court to recover the refund in June 2005. The parties stipulated that, to the extent that the refund claim was allowed, Quality Stores would also be entitled to recover interest on the claim.

Lower Court Decisions

In February 2008, the bankruptcy court ruled in favor of Quality Stores, holding that the claimants were not liable for FICA taxes and were entitled to a refund. In its opinion, the bankruptcy court relied, in part, upon the decision of the Court of Federal Claims in CSX Corp., Inc. v. United States, 52 Fed. Cl. 208 (Fed. Cl. 2002). However, subsequent to the bankruptcy court’s decision, the Federal Circuit issued its decision in CSX, reversing the Court of Federal Claims. Based upon CSX, the government moved for reconsideration of the bankruptcy court’s decision. In August 2008, the bankruptcy court granted the government’s motion for reconsideration but declined to follow the Federal Circuit’s decision in CSX and ratified its prior decision. The government appealed the bankruptcy court’s decision to the district court. In February 2010, the district court also declined to follow CSX and affirmed the bankruptcy court. In April 2010, the government appealed to the Sixth Circuit.

Origin of SUB Payments

In its opinion affirming the lower courts, the Sixth Circuit noted that the concept of SUB payments first appeared during the 1950s, evolving from the demand by organized labor for a guaranteed annual wage. SUB plans were developed to assure workers of employment security regardless of the number of hours actually worked, rather than to provide employees with additional compensation for work performed. When employers began adopting plans under collective bargaining agreements to fund trusts for the purpose of making SUB payments to employees in the event of unexpected job layoff or termination, it was critical that SUB payments not be characterized as “wages.” If SUB payments constituted wages, then unemployed workers could not qualify for unemployment benefits under most states’ laws, and the unavailability of unemployment benefits would largely defeat the purpose of SUB payments.

Definitions of ‘Wages’ and ‘SUB Payments’

Congress imposed the FICA tax on employee wages to fund the Social Security and Medicare programs. The employer collects the employee’s share by deducting the tax from wages as they are paid. The employer also pays a matching tax on the wages paid to the employee. Congress defined “wages” for FICA tax purposes (with certain exceptions) as “all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash ….” “Employment,” for purposes of FICA, means “any service, of whatever nature, performed … by an employee for the person employing him.” For purposes of income tax withholding, the Internal Revenue Code (“IRC”) contains a nearly identical definition of “wages.” In Rowan Cos. v. United States, 452 U.S. 247 (1981), the Supreme Court held that Congress intended the term “wages” to carry the same meaning for purposes of both FICA and federal income tax withholding.

The withholding tax provisions of the IRC contain the following definition of “SUB payments”:

amounts which are paid to an employee, pursuant to a plan to which the employer is a party, because of an employee’s involuntary separation from employment (whether or not such separation is temporary), resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions, but only to the extent such benefits are includable in the employee’s gross income. 26 U.S.C. §3402(o)(2)(A).

SUB Payments Are Not Wages

The parties had essentially stipulated that the severance payments made by Quality Stores satisfied this statutory definition. The Sixth Circuit noted that the IRC provides that a SUB payment “shall be treated as if it were a payment of wages” for purposes of the withholding tax provisions. The court found that the necessary implication arising from this phrase is that Congress did not consider SUB payments to be “wages,” but allowed their treatment as wages to facilitate federal income tax withholding for taxpayers. The court further found that Congress’s intention that SUB payments not constitute wages was supported by the legislative history. Thus, the Sixth Circuit concluded that, even though SUB payments are treated as wages for purposes of income tax withholding, all of such payments actually constitute non-wages. Moreover, because Rowan requires that the term “wages” be given the same meaning for purposes of FICA and income tax withholding, the court held that all SUB payments also constitute non-wages for purposes of FICA.

Sixth Circuit Rejects the Government’s Other Arguments

The Sixth Circuit rejected the government’s argument that Congress had legislatively superseded Rowan when it enacted the so-called “decoupling amendment” as part of the Social Security Amendments of 1983. That amendment, as written, authorized the Treasury Department to promulgate regulations to provide for different exclusions from “wages” under FICA than under the income tax withholding provisions. But, the court noted, the Secretary of the Treasury has never promulgated any regulations under the decoupling amendment.

The Sixth Circuit also rejected the government’s argument that Rowan was eroded by the Supreme Court’s decision in Environmental Defense Fund v. Duke Energy Corp., 549 U.S. 561 (2007). On this point, the Sixth Circuit agreed with the reasoning of the Federal Circuit, which in CSX held that Duke Energy did not affect the continuing validity of Rowan. The Sixth Circuit also rejected the government’s argument that the Supreme Court’s decision in Mayo Found. for Med. Educ. & Research v. United States, 131 S. Ct. 704 (2011), undercut the validity of Rowan. In Mayo Found., the Supreme Court concerned itself with Rowan’s status as a case decided before Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984), which accorded less deference to a Treasury regulation than is now required under Chevron. However, the court held that Mayo Found. added nothing of significance to the legal analysis in the present case.

Sixth Circuit Declines to Follow the Federal Circuit

The Sixth Circuit’s holding that Rowan remains good law was consistent with the Federal Circuit’s decision in CSX. However, the Sixth Circuit disagreed with one significant aspect of the Federal Circuit’s decision in CSX. The Federal Circuit in CSX had confined the congressional definition of SUB pay in IRC § 3402(o) to federal income tax withholding only and did not rely on Rowan to conclude that the same statutory definition applies to FICA tax. The Sixth Circuit disagreed with this analysis, finding it to be inconsistent with other authority in the Federal Circuit. The Sixth Circuit relied on Rowan to reach the conclusion that if Congress decided that all SUB payments are non-wages for purposes of federal income tax withholding, then all SUB payments are also non-wages for purposes of FICA.

Revenue Rulings Did Not Control Decision

Finally, the Sixth Circuit found that the revenue rulings relied upon by the government did not alter its opinion. The court held that it would not accept the government’s argument, which would have given greater significance to the IRS’s revenue and private letter rulings than to congressional intent as expressed in the statutory language and legislative history.

Subsequent Developments

On October 18, 2012, the government filed a petition for rehearing en banc and on December 14, 2012, the appellees filed a response opposing the government’s petition. If the petition is granted, the panel’s decision will be reviewed by all of the judges in regular active service on the Sixth Circuit. If the petition is denied, many observers expect the government to ask the U.S. Supreme Court to review the decision and believe there is a good chance that the Court would accept the case for review. However, it is also possible that the government will not seek to have the Supreme Court review the case but rather will continue to litigate the issues in other circuits. In the meantime, Quality Stores will provide strong support to taxpayers seeking refunds of FICA taxes paid in connection with the many workforce reductions that have occurred during the Great Recession.

Written by:

Pepper Hamilton LLP

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