On September 7, 2012, the Sixth Circuit Court of Appeals, in United States v. Quality Stores, Inc., ruled that severance payments made to laid off employees, under certain circumstances, do not constitute “wages” subject to tax withholding under the Federal Insurance Contributions Act (FICA).
Quality Stores and its affiliated companies went through Chapter 11 bankruptcy proceedings beginning in October 2001. By November 1, 2001, Quality Stores had closed many of its stores and several distribution centers and had laid off 75 employees in its corporate office. Eventually, Quality Stores closed its remaining stores and distribution centers and terminated all remaining employees.
Prior to the bankruptcy petition’s filing, Quality Stores created a severance plan for employees whose jobs it terminated due to its reduction-in-force or the shutdown of a plant or operation. Under this plan, Quality Stores based the severance each employee received on the employee’s job grade and management level. With the exception of senior management executives, the managers and employees who participated in the plan received one week of severance pay for each full year of service.
After the bankruptcy petition’s filing, Quality Stores created a second severance plan, which it “designed to encourage [remaining] employees to defer their job searches and dedicate their efforts and attention to the company by assuring them that they would receive severance pay if their jobs were eliminated.” Aside from some officers, full-time salaried employees received one week of severance for each full year of service, up to a maximum of 10 weeks, while full-time hourly employees received one week of severance for each full year of service, up to a maximum of five weeks. Employees who had “less than two years of service received one week of severance pay.”
Under both severance plans, an employee’s receipt of severance payments was not tied to his/her receipt of unemployment benefits and “were not attributable to the provision of any particular services by the employees.” Quality Stores withheld federal income tax from all of the severance payments. It also withheld FICA contributions from, and paid its share of FICA contributions for, each severance payment.
Quality Stores sought a refund of its FICA contributions for all severance payments, as well as refunds on behalf of 1,850 former employees (out of 3,100) who authorized Quality Stores to seek, on their behalf, refunds of their share of FICA withholdings. In total, Quality Stores sought a refund of $1,000,125. The IRS denied the refund, and “Quality Stores filed an adversary action in the bankruptcy court[,]” which ruled in Quality Stores’ favor and ordered a refund. The IRS appealed to federal district court, and that court also ruled in favor of Quality Stores.
On appeal, the Court of Appeals for the Sixth Circuit agreed with the bankruptcy court that the severance “payments Quality Stores made to its employees upon terminating their employment involuntarily due to business cessation constituted supplemental unemployment compensation benefits (SUB payments) that are not taxable as wages under FICA.” In rejecting the IRS’s arguments that the SUB payments were wages for purposes of FICA, the court focused on how the tax code defines “wages” and “employment” for income tax and FICA withholding purposes.
FICA defines “wages” as “all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash[,]” and “employment” as “any service, of whatever nature, performed . . . by an employee for the person employing him . . .” (Quoting I.R.C. s. 3121(a) & (b)). The court reasoned that the SUB payments at issue “f[ell] outside the broad statutory meaning of service performed by an employee for an employer because, by definition, an employee is not eligible for SUB pay until service to the employer has ended and such benefits provide compensation for the lost job.”
The court pointed out that FICA’s definition of “wages” is “nearly identical” to the definition of “wages” used for federal income tax withholding, I.R.C. s. 3402. Further, the court focused on the fact that “Congress expressly defined SUB payments for purposes of federal income tax withholding in a subsection of the statute entitled, “Extension of withholding to certain payments other than wages“ (emphasis in original). According to the court, Congress’ use of the phrase “other than wages” illustrates that it did not consider SUB payments to be “wages.” Nevertheless, for income tax withholding purposes, Congress decided to treat SUB payments as wages, which are not to be confused with gross income. Since SUB payments constitute gross income to the employee, the court explained that, in part, Congress wanted to avoid the possibility that a laid-off employee would receive a large tax bill when filing a tax return because his/her former employer did not withhold federal income taxes from the SUB payments.
The court also noted that FICA “does not expressly include or exclude SUB payments, nor do the Treasury regulations promulgated under FICA address the subject.” Because FICA uses a “nearly identical” definition of “wages” as the federal income tax statute, the court ruled that it must interpret both definitions consistently. Thus, if SUB payments are not “wages” for income tax withholding purposes (although they are treated as such to avoid big tax bills for employees at filing time), the court ruled that SUB payments cannot be “wages” under FICA’s “nearly identical” definition. Since FICA does not contain a provision requiring employers to treat SUB payments as wages, no FICA withholdings are required from SUB payments, the court reasoned.
The court outlined the elements that severance payments need to meet to qualify as SUB payments not subject to FICA withholding as follows:
- An amount paid to an employee;
- Pursuant to an employer’s plan;
- Because of an employee’s involuntary separation from employment, whether temporary or permanent;
- Resulting from a reduction-in-force, the discontinuance of a plant or operation, or other similar conditions; and
- Included in the employee’s gross income.
The court emphasized that, based on the tax code’s definition of wages for income tax withholding purposes, a determination that severance constitutes SUB payments in no way hinges on whether the payments are “tied to an employee’s receipt of state unemployment compensation benefits, nor does the statute make any distinction between periodic payments or one-time payments made in a lump sum.”
So, what should employers do the next time they offer employees a severance package that meets the definition of SUB payments? Should an employer rely on Quality Stores to avoid making employer FICA contributions?
While employers, particularly those in Michigan, Ohio, Kentucky and Tennessee (i.e., the Sixth Circuit), may be tempted to rely on Quality Stores to avoid making employer FICA contributions, there is risk involved in this approach. Arguably, Quality Stores created a conflict with CSX Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008), which makes a review by the Supreme Court more likely. If the Supreme Court reversed Quality Stores, it is possible that the IRS would retroactively seek FICA contributions from an employer, especially one outside of the Sixth Circuit. In addition, an employer would need to collect FICA contributions from each employee to whom it paid a severance. The employer could be liable for any employee contributions that it cannot collect. Given that the affected employees would be separated employees, collection may be extremely difficult.
Based on these risks, the safest approach, for now, is to continue withholding FICA contributions from an employee’s severance and for the employer to continue making its own contributions. If an employer chose to make a refund claim, the employer would attempt to rely on Quality Stores as support for making such a claim. When and if the IRS may refund these amounts may depend on whether an employer is located in the Sixth Circuit and whether the IRS or the Department of Justice pursue a review of the Quality Stores case (and the result of such a review). Regardless of location, employers could begin the process of seeking refund claims now, before the applicable statute of limitations expires (currently open for tax years 2009, 2010 and 2011 through April 15, 2013).