In United States v. Quality Stores, Inc., the US Supreme Court will address the question of whether certain severance payments to involuntarily terminated employees are subject to Federal Insurance Contribution Act ("FICA") taxes (i.e., Social Security and Medicare taxes). The question is fundamentally one of statutory interpretation and turns on two component issues: whether to draw an inference from a particular income tax withholding statute and whether the definition of wages can be different for income tax withholding purposes and FICA tax purposes. The government has asserted that this is an important and recurring issue affecting more than one billion dollars in pending claims.
Under the Internal Revenue Code (the "Code"), all wages are generally subject to FICA taxes. With some exceptions, severance payments are generally considered "wages." There is uncertainty, however, as to whether a particular type of severance payment, known as supplemental unemployment benefits ("SUB" payments), is appropriately considered "wages" and thus subject to FICA taxes. The Code directs that SUB payments are subject to income tax withholding, and for that purpose, defines them as amounts paid to an employee "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." The FICA statute, however, does not define SUB payments, and no Treasury Regulations have been promulgated expressly addressing whether SUB payments constitute wages subject to FICA taxes. Taxpayers have read the income tax withholding statute, which says SUB payments are to be "treated as" wages subject to withholding, to mean that SUB payments must not be wages and are thus exempt from FICA taxes. The Internal Revenue Service ("IRS") has rejected this argument and takes the position that all SUB payments are wages subject to FICA taxes unless the SUB payments satisfy the requirements set forth in a series of administrative rulings published by the IRS between 1956 and 1990. Although these administrative rulings contain some internal inconsistencies, they generally require, among other things, that SUB payments be linked to, and designed to supplement, state unemployment compensation in order to escape the imposition of FICA taxes. Many of the administrative requirements included in the rulings do not appear in the statutory definition of SUB payments used for income tax withholding purposes.
The dispute as to whether SUB payments are wages subject to FICA taxes was the central issue in both Quality Stores and CSX Corp. v. US. In CSX Corp, the Court of Appeals for the Federal Circuit held that severance payments CSX made to its former employees constituted wages subject to FICA taxes. The Federal Circuit concluded that SUB payments are wages and declined to read the statutory language of the income tax withholding statute as implying that SUB payments are not wages. It then concluded that, as wages, the SUB payments were subject to FICA taxes given that they did not satisfy the IRS's administratively established criteria for FICA-exempt SUB payments. In Quality Stores, the US Court of Appeals for the Sixth Circuit came to the opposite conclusion on this same issue. The Sixth Circuit held that similar severance payments made by Quality Stores were SUB payments under the statutory definition used for income tax withholding purposes (though not under the IRS's administrative rulings) and, therefore were not wages subject to FICA taxes.
The Sixth Circuit's holding in Quality Stores directly conflicts with the Federal Circuit's earlier holding in
Over 2,400 claims for FICA tax refunds totaling more than one billion dollars are riding on the outcome of this case. In 2013, the IRS suspended all refund claims for FICA taxes in the Sixth Circuit (Kentucky, Tennessee, Ohio and Michigan) pending the resolution of this issue. The IRS has been denying refund claims filed by taxpayers outside the Sixth Circuit, though the IRS has generally been willing to sign Form 907 (Agreement to Extend the Time to Bring Suit) for those taxpayers whose claims are formally disallowed, giving them time to watch the outcome of the pending litigation before deciding whether to bring their own refund suits.
Ultimately, if Quality Stores prevails, the government will need to resolve the backlog of outstanding claims. For employers who filed refund claims that were denied, the Supreme Court may open the possibility of suing for a refund. For employers who have downsized and paid FICA taxes on severance payments in the last three years but have not yet filed refund claims, this case could present a potential refund opportunity. Employers should consider taking affirmative steps to prepare themselves in case the court rules for Quality Stores:
• Any employer that made SUB payments and has not already filed a protective claim with the IRS to ensure that the three-year statute of limitations does not run may want to do so. Protective claims will help ensure that employers and employees are entitled to receive a refund for FICA taxes withheld from qualifying severance payments.
• Any employer that filed a refund claim for FICA tax on SUB payments that was denied will want to review the litigation procedures necessary to pursue a refund in the event the Supreme Court rules for Quality Stores.
• Employers who want to pursue refund claims should have internal procedures in place for securing employee consents. In general, treasury regulations require that employers seeking a refund of FICA taxes must pay the employee his or her share of the refund or obtain the employee's consent to request a refund. If the employer makes reasonable efforts to find an employee to seek a consent, and the efforts fail, the employer can still recover its share of the FICA tax. The employer can file a protective refund claim without first securing the consents, but will need the consents, or evidence of reasonable efforts to secure them, in order to perfect the claim and receive payment. Employers might consider making tax refund consent forms part of their standard separation procedures for employees who are going to receive severance payments following an involuntary termination.
Finally, even if Quality Stores prevails, the government may have the opportunity to change the answer prospectively by writing new regulations. Depending upon what the Supreme Court says in its decision about the income tax withholding provision that both sides have invoked in their arguments, the IRS may be authorized to write regulations separating the treatment of severance payments for income tax withholding purposes and for FICA tax purposes.
Catherine E. Livingston is a partner in Jones Day's health care and tax practices in its Washington D.C. office. Lori Hellkamp is an associate in Jones Day's tax practice in its Washington office. The opinions expressed in this article are solely those of the authors and do not necessarily reflect the viewpoints of Jones Day.
Suggested citation: Catherine E. Livingston and Lori Hellkamp, When are Severance Payments Subject to FICA Taxes? Supreme Court to End Circuit Split, JURIST - Sidebar, Jan. 21, 2014, http://jurist.org/sidebar/2014/01/livingston-hellkamp-fica-severance.php.
This article was prepared for publication by Stephanie Kogut, Section Head for JURIST's professional commentary service. Please direct any questions or comments to her at email@example.com