Split by Courts on Severance Pay Under FICA Could Lead to Billions of Dollars in Refunds

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The recent decision by a federal appeals court that Federal Insurance Contributions Act taxes do not apply to nonwage payments made to former employees under particular separation or severance programs could make available billions of dollars in FICA refunds, experts said.

In the case (United States v. Quality Stores Inc. (In re Quality Stores Inc.), 6th Cir., No. 10-1563, 9/7/12), the court rejected the government's position and the federal circuit's ruling in CSX Corp. v. United States (Fed. Cir. 2008) that the payments were dismissal pay subject to FICA taxes, upholding earlier bankruptcy court and district court rulings in favor of Quality Stores.

In comments made last year about the case, Mary B. Hevener, a partner at Morgan, Lewis & Bockius in Washington and a tax and benefits counsel to the American Payroll Association, said the argument against the Internal Revenue Service interpretation is so strong that the agency should develop a settlement program and issue clarifying, prospective regulations to guide employers.

Should the IRS take the position that the payments are not FICA taxable, affected employers could potentially make claims for billions of dollars in FICA tax refunds, Hevener said.

Payments Not Defined as Wages, Court Says

The Internal Revenue Service has allowed only a narrow exception from FICA taxation of layoff benefits through the mechanism of supplemental unemployment benefit (SUB) plans, saying the amounts paid must be tied to unemployment insurance claims and payments.

While the Quality Stores severance plan payments were not connected to the receipt of state unemployment compensation, there also was no particular employment service rendered. The payments were, in effect, made for not working. FICA taxes were withheld, but the employer applied for a refund of the FICA amounts, claiming the amounts paid were not wages as defined under the law. IRS denied the refund.

Determining whether the payments are wages under FICA is complicated because the FICA statute and Treasury Department regulations do not address the issue, said Sixth Circuit Judge Jane B. Stranch. Just because the payments stemming from involuntary separation, a reduction in force or similar condition, are included in the employee's gross income for federal tax purposes does not mean the amounts also are FICA taxable, Stranch said.

Finding that Congress characterized SUB payments as nonwage payments in the tax code, Stranch determined that the payments by Quality Stores qualify as nonwage payments that were not subject to FICA taxes.

The IRS revenue rulings that the United States relied on in its argument in support of FICA taxation of the payment were “inconsistent with the intent of Congress,” Stranch said.

Noting that the Sixth Circuit's decision conflicts with the Federal Circuit's decision in CSX, Stranch said the Supreme Court might ultimately resolve the conflict between the circuit courts on the taxability of the payments but the court's role is to interpret the statute according to the intent of Congress.