Pepper Victory: Sixth Circuit Holds that Supplemental Unemployment Compensation Benefits Are Not ‘Wages’ Subject to FICA Taxation

by Pepper Hamilton LLP

[authors: Robert S. Hertzberg, Michael H. Reed and Lisa B. Petkun]

In an important recent decision, United States v. Quality Stores, Inc., et al.,1 in which Pepper represented the prevailing party, 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,2 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) and it is estimated that there are similar pending refund claims totaling over $4 million.


Quality Stores, Inc. was the largest agriculture-specialty retailer in the country serving farmers, hobby gardeners, skilled tradepersons, and do-it-yourself customers. In October 2001, an involuntary Chapter 11 bankruptcy petition was filed against Quality Stores. Quality Stores consented to the Chapter 11 petition and its affiliates subsequently filed voluntary Chapter 11 petitions. Prior to and shortly after filing for bankruptcy, Quality Stores closed all of its stores and distribution centers and terminated all of its employees. Quality Stores made severance payments to those employees whose employment was involuntarily terminated pursuant to two severance plans, one established before it filed for bankruptcy and the other established during the bankruptcy case. Neither of the severance plans tied the payments to the receipt of state unemployment compensation, nor were the payments attributable to the provision of any particular services by the employees. The parties stipulated that the severance payments “resulted directly from a reduction in force or the discontinuance of a plant or operation.”

Because the severance payments constituted gross income to the employees for federal income tax purposes, 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 8-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 forms 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.3 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.4 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.5 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.”6 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.’”7 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.”8

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 …”9 “Employment,” for purposes of FICA, means “any service, of whatever nature, performed … by an employee for the person employing him.”10 For purposes of income tax withholding, the Internal Revenue Code (IRC) contains a nearly identical definition of “wages.”11 In Rowan Cos. v. United States,12 the Supreme Court examined the plain language and legislative histories of the FICA and income tax withholding provisions and concluded 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 also 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.13

SUB Payments Are Not Wages

Based upon the undisputed facts as stipulated by the parties, the Sixth Circuit had little difficulty finding that the severance payments made by Quality Stores satisfied this statutory definition. The court then 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.14 “In our view, 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.” 15 The court further found that Congress’s intention that SUB payments not constitute wages was supported by the legislative history. Thus, based on its analysis of the statutory language and the legislative history, the Sixth Circuit concluded that all SUB payments constitute non-wages for purposes of the income tax withholding provisions of the IRC. 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 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 1983.16 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.17 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,18 undercut the validity of Rowan. In Mayo Found., the Supreme Court concerned itself with Rowan’s status as a pre-Chevron19 case that accorded less deference to a Treasury regulation than is now required under Chevron. However, Mayo Found. added nothing of significance to the legal analysis in this case, the court held.

Sixth Circuit Declines to Follow the Federal Circuit

The Sixth Circuit noted that its holding that Rowan remains good law is consistent with the Federal Circuit’s decision in CSX. However, the Federal Circuit in CSX had “confined the congressional definition of SUB pay in I.R.C. §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.”20 The Sixth Circuit not only disagreed with this analysis, but found it to be inconsistent with other authority in the Federal Circuit. “By contrast to the analysis of the Federal Circuit, we rely on Rowan to reach the conclusion that if Congress decided to treat SUB payments as if they were ‘wages’ for purposes of federal income tax withholding, then the same definition must apply under FICA.”21

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. “We decline to imbue the IRS revenue rulings and private letter rulings with greater significance than the congressional intent expressed in the applicable statutes and legislative histories.”22

Conclusion and Takeaways

In its conclusion, the Sixth Circuit conceded that the issue of statutory construction in the case was “complex” and speculated that “the Supreme Court may ultimately provide us with the correct resolution of these difficult issues under the law as it currently stands.”23

Quality Stores has been a closely watched case. The Sixth Circuit’s decision is an important precedent on several aspects of tax law, including the continuing validity of Rowan and the interpretation of, and judicial deference to be afforded to, revenue rulings. It appears likely that the government will seek to have the Sixth Circuit’s decision reviewed by the U.S. Supreme Court. 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. Employers and other taxpayers should consult their tax advisors concerning the possible implications of this decision.

* * * *

Appellees Quality Stores, Inc., et al. are represented by the authors, Robert S. Hertzberg, co-chairman of the Corporate Restructuring and Bankruptcy Group of Pepper Hamilton LLP and Michael H. Reed, a senior partner in Pepper’s Corporate Restructuring and Bankruptcy Group. Messrs. Hertzberg and Reed also consulted with author Lisa Petkun, a partner in Pepper’s Tax Group.


1 Case No. 10-1563, 2012 U.S. App. LEXIS 18820 (6th Cir., Sept. 7, 2012).

2 518 F.3d 1328 (Fed. Cir. 2008).

3 See Quality Stores, Inc. v. United States (In re Quality Stores, Inc.), 383 B.R. 67 (Bankr. W.D. Mich. 2008).

4 52 Fed. Cl. 208 (Fed. Cl. 2002).

5 See United States v. Quality Stores, Inc. (In re Quality Stores, Inc.), 424 B.R. 237 (W.D. Mich. 2010).

6 2012 U.S. App. LEXIS 18820 at *9, citing Coffy v. Republic Steel Corp., 447 U.S. 191, 200 (1980).

7 2012 U.S. App. LEXIS 18820 at *31-*32.

8 Id. at *32.

9 26 U.S.C. §3121(a).

10 26 U.S.C. §3121(b).

11 See 26 U.S.C. §3401(a).

12 452 U.S. 247 (1981).

13 26 U.S.C. §3402(o)(2)(A).

14 See 26 U.S.C. §3402(o)(1) (emphasis added).

15 2012 U.S. App. LEXIS 18820 at *15.

16 Pub. L. No. 98-21, 97 Stat. 65 (1983).

17 549 U.S. 561 (2007).

18 131 S. Ct. 704 (2011).

19 Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984).

20 2012 U.S. App. LEXIS 18820 at *26, citing CSX, 518 F.3d at 1340-42, 1345.

21 Id. at *26-*27.

22 Id. at *38.

23 Id. at *39-*40.



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