In US v. Quality Stores, Inc., the Supreme Court once again backed the Internal Revenue Service's (IRS) interpretation of tax law, holding (PDF) that severance payments were taxable for Federal Insurance Contributions Act (FICA) purposes. The case was closely watched because a decision in favor of the taxpayer could have resulted in over $1 billion in refund claims. While holding in favor of the IRS, the court still acknowledged that certain supplemental unemployment compensation benefits ("SUB pay") may be exempt from FICA if properly structured.
Quality Stores, Inc. (Quality) operated a chain of retail stores. Falling on hard times, it entered Chapter 11 bankruptcy in late 2001. As a result, Quality initially closed many of its retail stores and laid off numerous employees before eventually closing all stores and laying off all employees. When Quality terminated employees, it made severance payments to them under its severance plans. The severance was paid as a direct result of the employees' involuntary separation from employment. The severance payments were not tied to the receipt of state unemployment compensation and were not attributable to the rendering of any particular past or future employment. Quality reported the severance payments as wages on employees' W-2 forms and withheld federal income tax and the employees' share of FICA taxes. It also paid the employer's share of FICA taxes on the severance payments.
In 2002, Quality filed refund claims with the IRS for overpaid FICA on the severance payments (plus interest on the overpayment). The claims included both the employer's and the employees' share of FICA (for those employees who consented to Quality making the refund request for them).
The bankruptcy court ruled in favor of Quality, finding that the severance payments were not "wages" for purposes of FICA taxes. The IRS appealed to the federal district court, which affirmed the bankruptcy court, concluding that, because the severance payments met the definition of "SUB pay" under Internal Revenue Code (IRC) § 3402(o)(2), they were not "wages" for purposes of income tax or FICA withholding.
The IRS then appealed to the US Court of Appeals for the Sixth Circuit, which also held for the taxpayer. The court began by defining the two issues before it as: (1) whether the payments by Quality constituted SUB payments under federal law; and (2) if so, whether the payments were taxable under FICA. Utilizing the definition in IRC § 3402(o), the court quickly determined that the payments qualified as SUB payments because they had been: (1) made to employees; (2) pursuant to company plans; (3) due to the employees' permanent separation of employment; (4) resulting directly from a reduction in force or discontinuance of a plant or operation; and (5) were included in the employees' gross incomes. It then concluded, based on the heading to the section covering IRC § 3402(o) and the legislative history of the statute, that SUB payments "do not constitute wages or remunerations for services."
The Sixth Circuit acknowledged its holding was in direct contrast to the holding in CSX Corp. v. United States, which held that SUB pay was wages subject to FICA, and made a thinly veiled plea to the US Supreme Court to "provide us with the current resolution of these difficult issues under the law as it currently stands" or for Congress to "clarify the statutes concerning the imposition of FICA taxes on SUB payments."
The Supreme Court granted the IRS' petition for certiorari. In a short 8-0 decision, the court appeared to have little problem finding SUB pay to be wages. Relying solely on the "plain meaning" of the IRC, the court held that severance was paid to employees for services in employment, and thus constitutes wages for purposes of FICA. The court also noted that, under IRC § 3121(a)(13)(A), the specific exemption for severance payments based on disability would not have been necessary if severance payments generally were not wages.
The court then turned to whether § 3402(o), relating to income-tax withholding, was a limitation on the meaning of "wages" for FICA purposes. At issue was the language "as if wages" contained in the section, with Quality arguing that it must mean that SUB pay was not wages, or else the language "as if" would be superfluous. But the court found such language was not as limiting as Quality argued, citing to the explanation used by the Federal Circuit in CSX Corp.: "all men shall be treated as if they were six feet tall does not imply that no men are six feet tall."
After reviewing the purpose of the treatment of SUB pay as exempt from FICA and the problem Congress sought to resolve relating to income tax withholding, the court held that the Sixth Circuit's rationalea larger set of SUB pay arrangements than was already exempt from withholding under IRS revenue rulings meaning that all SUB pay arrangements were excluded from the definition of wageswas not sustainable, even if not entirely illogical. The court concluded: "The better reading is that Congress determined that, whatever position the IRS took with respect to certain categories of severance payments, the problem with withholding should be solved by treating all severance payments as wages requiring withholding." Finally, citing IRS Revenue Ruling 90-72, the court acknowledged that SUB pay can still be excluded from FICA, although Quality's severance plans did not meet the requirements of the Revenue Ruling, and was thus not at issue.
For the second time in two years, the court has addressed specific exemptions from FICA potentially worth billions of dollars to taxpayers. In 2011, in Mayo Foundation v. United States, the court held that the Treasury Department's regulation defining medical residents for purposes of the FICA student exemption was reasonable. In Quality Stores the court implicitly endorsed the IRS's interpretation of § 3402(o), while passing the question of whether IRS revenue rulings defining exempt SUB pay were themselves reasonable.
In light of CSX Corp., and the IRS' long-standing interpretation of FICA, the court's decision is not really a dramatic departure of any kind. Rather, it appears to continue the court's deference to the IRS' interpretation of tax lawwhether it is interpreting its own regulations or the plain meaning of the IRC. Much of the court's decision in Quality Stores appears grounded in a common sense approach to reading the IRC, rather than being overly technical about the meaning of the law. That taxpayer only took the position as a claim for refund, rather than a filing position, possibly suggesting that it was being cautious about the legal underpinnings of the position.
In Revenue Ruling 90-72 the IRS set forth eight criteria for creating exempt SUB pay:
(1) Benefits are paid only to unemployed former employees who are laid off by the employer;
(2) Eligibility for benefits depends upon meeting prescribed conditions after terminating employment with the employer;
(3) Benefits are paid by trustees of independent trusts;
(4) The amount of weekly benefits payable is based upon state unemployment benefits, other compensation allowable under state laws, and the amount of straight-time weekly pay;
(5) The duration of the benefits is affected by the fund level and the employee's seniority;
(6) The right to benefits does not accrue until a prescribed period after termination of employment;
(7) The benefits are not attributable to the rendering of particular services; and
(8) No employee has any right, title, or interest in the fund until such employee is qualified and eligible to receive benefits.
These requirements, which derive from Revenue Ruling 56-249, mean that employers need to fund a trust out of which benefits are paid to employees, with the amount paid being tied to the employees' receipt of state unemployment benefits. As originally conceived in the 1950s, the idea of SUB pay was that if an employee earned $100 per week in wages, but only received $60 in state unemployment benefits, the SUB pay would be $40, so that the employee was essentially "whole." But severance plans today do not typically work that way. Rather, severance plans may pay a lump sum upon termination, often in exchange for a release by the employee of any employment-related claim the employee might otherwise bring. The amounts are not paid out of a trust, nor are they tied to the employee's receipt of state unemployment benefits. An employee who obtains other employment immediately following his or her termination would still receive severance even though never receiving unemployment benefits. This appears to be very different from the concept of SUB pay as originally designed.
The court's decision does not hold that SUB pay cannot be exempt from FICA; only that severance paid under plans that are commonly in place nowboth lump sums paid directly by the employer to employees or salary continuation payments that are essentially the same as regular wagesare not exempt from FICA. Employers still could comply with Revenue Ruling 90-72 so as to be in a position to have SUB pay plans where the payments are exempt from FICA.
Taxpayers could also challenge the IRS's requirements set forth in Revenue Ruling 90-72 as not being a reasonable interpretation of the definition of SUB pay. For example, taxpayers could take the position that the trust requirement to qualify as exempt SUB pay is an unreasonable extension of the IRC. Employers could also try working with either the IRS or Congress to create a more usable definition of SUB pay. Moreover, employers could fashion both exempt SUB pay and non-exempt SUB pay plans in combination, although it is questionable whether the tax savings would be worth the effort.
The Quality Stores case is another example of creative practitioners seeking to exploit ambiguities in tax law. There is no reason not to try, but the court's decision upholding the government's interpretation suggests taxpayers face an uphill battle in their attempts to do so.
William Hays Weissman is is a shareholder with Littler Mendelson who specializes in employment taxes and OFCCP/Affirmative Action audits. In addition to receiving his J.D. from District of Columbia School of Law, he also holds an L.L.M. and an M.B.A.
Suggested citation: William Hays Weissman, ourt Backs IRS in Fight Over the Tax Treatment of Severance, JURIST - Professional Commentary, Apr. 15 2014, http://jurist.org/hotline/2014/04/william-weissman-irs-refunds.php.
This article was prepared for publication by Michael Muha, an associate editor with JURIST's professional commentary service. Please direct any questions or comments to him at email@example.com