In a decision having significant impact, the Sixth Circuit ruled that payments to employees as part of a severance program are not subject to tax under the Federal Insurance Contributions Act, or FICA. The IRS is fighting the decision. Employers should file protective claims before the statute of limitations runs out.
The case involves whether the income tax treatment of severance payments can be decoupled from the FICA treatment for the same wages. Supplemental Unemployment Compensation Benefits (SUB) are exempt from FICA taxes. SUB payments to employees are excluded from the definition of “wages” for FICA purposes IF the amounts are paid to an employee:
- Because of an employee’s involuntary separation from employment; and
- Resulting directly from a reduction in force, the discontinuance of a plant or other similar conditions (IRC §3402(o)(2)(A).)
The Sixth Circuit’s ruling in re: U.S. vs. Quality Stores, Inc. (No. 10-1563, September 7, 2012) upheld findings made by the bankruptcy court and district court. The ruling places the Sixth circuit in direct conflict with the Federal Circuit, where the Internal Revenue Service (IRS) won in re: CSX Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008).
The CSX decision held that to be exempt from FICA, severance payments must meet the requirements of Revenue Ruling 90-72 and Revenue Ruling 56‑249, which are more restrictive than the requirements summarized above. Under Rev. Rul. 90-72, to be exempt from “wages” under FICA, SUB payments must be made pursuant to a plan designed to supplement state unemployment compensation. Accordingly, severance pay is exempt from FICA as a SUB only if linked to the continued receipt of state unemployment benefits. Additionally, the IRS ruled that lump sum payments are not linked to state unemployment compensation and therefore are not excludable from FICA.
The Sixth’s Circuit arrived at its decision by reviewing the Internal Revenue Code, specifically IRC §3402(o). Their rationale is as follows:
“Parsing this definition into its five separate elements, Congress has provided that a SUB payment is: (1) an amount paid to an employee; (2) pursuant to an employer’s plan; (3) because of an employee’s involuntary separation from employment, whether temporary or permanent; (4) resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions; and (5) included in the employee’s gross income. …
Because the title and legislative history clarify any ambiguity in the statute, we are convinced that Congress characterized SUB payments as “non-wages” and Congress enacted § 3402(o) simply to extend withholding to these “non-wage” payments to benefit taxpayers. In light of this clear congressional intent, we approve the bankruptcy court’s reasoning that if SUB payments are not “wages” but are only treated as if they were “wages” for purposes of federal income tax withholding, then SUB payments also are not “wages” under the nearly identical definition of that term found in the FICA statute. The analytical bridge for this step in our reasoning arises from the Supreme Court’s decision in Rowan Cos. v. United States, 452 U.S. 247, 255–57 (1981).”
The IRS maintains its previous position under Rev. Rul. 90-72 regarding the employment tax treatment of SUB pay. On October 18, the IRS filed a petition for the Sixth Circuit’s rehearing of the case en banc. If the Sixth Circuit does not grant rehearing en banc or issues an en banc opinion that is still unfavorable to the IRS, the IRS informally indicated it will seek Supreme Court review. According to the government’s petition for rehearing en banc, (i) the IRS suspended action on administrative refund claims that already exist, and (ii) the total tax exposure exceeds $1 billion.
It is relatively easy for an employer to file a protective claim to preserve the statute of limitations on employment tax refund claims for open years. The due date for the protective claim is three years from April 15 of the calendar following the year in which the severance payments were made. For example, for FICA taxes paid in 2009, a protective claim should be filed by April 15, 2013.
The refund claim uses Form 941-X. The Form 941-X explanation should specify that the claim is being filed as a protective claim based on the Quality Stores court decision. The corrected wage column will reflect the reduced wages after subtracting the severance wages. The result is a refund of Social Security and Medicare taxes on both employer and employee share of the severance wages. The refund claim should include Form 8275, which is used to disclose positions taken on a tax return that are contrary to IRS guidance. Form 8275 should be filed because the refund request conflicts with Revenue Rulings 90-72 and 56-249.
Because of the wide application of this issue to all of the layoffs that occurred during the recent downturn, and the clear Circuit split, a good chance exists that the Supreme Court will accept the case. Congress could also resolve the issue to avoid making the deficit worse.