The Sixth Circuit Court of Appeals has affirmed a district court decision in U.S. v Quality Stores, Inc. (No. 10-1563), holding that severance payments made to employees upon terminating their employment involuntarily due to business cessation are not subject to payroll taxes under the Federal Insurance Contributions Act (FICA). The decision, unless appealed to the Supreme Court, should allow taxpayers in the Sixth Circuit to obtain refunds for FICA taxes paid on similar severance payments. The IRS could continue to deny refund claims in other circuits based on the prior decision from the U.S. Court of Appeals for the Federal Circuit in CSX Corp. v United States (518 F.3d 1328).
The decisions
Under FICA, wages are generally subject to matching employer and employee contributions for Social Security and Medicare taxes. The IRS has long argued that severance payments made at the separation of service are wages for FICA tax purposes, and the Federal Circuit agreed with the IRS in CSX in 2008. But the Sixth Circuit has now ruled in Quality Stores that severance payments the taxpayer made upon terminating employees should be considered supplemental unemployment benefits (SUB) payments, exempt from FICA.
What they mean
The Sixth Circuit opinion effectively rules that severance payments for involuntary separation from employment resulting directly from a reduction in work force, the discontinuance of a plant or operation, or other similar conditions, should not be subject to FICA taxes, but acknowledged the complexity of the issue and noted that the Supreme Court may ultimately have to rule. The IRS has 90 days from the Sept. 7 decision to appeal to the Supreme Court but may first ask for a rehearing of the case in the Sixth Circuit. If the decision is not appealed, employers located in Kentucky, Michigan, Ohio and Tennessee (states in the Sixth Circuit) should be able to successfully execute refund claims for FICA taxes on severance payments. If the decision is appealed, taxpayers in these states should file protective refund claims if they have not done so already.
For employers outside these states, it is more complicated. The IRS has been denying protective refund claims outright based on the CSX decision and could continue to do so, even if it does not appeal Quality Stores. Taxpayers outside the Sixth Circuit should still consider filing protective refund claims if they have not done so already, and they have several options if their claims are denied by the IRS.
Responding to a denied claim
A protective claim is contingent on a future event that may not be determinable until after the time period for filing a claim expires. Employers who have not yet filed protective claims but paid significant severance payments from 2009 through 2011 (years for which the statute of limitations is still open) should consider filing to keep these years open. This is especially important now for 2009 claims, since the statute of limitations will expire on April 15, 2013. The IRS will generally delay action on a protective claim until the contingency is resolved but has been denying protective claims made outside the Sixth Circuit by arguing that CSX is settled and controlling in all other jurisdictions.
Taxpayers who have already received or will receive a notice of disallowance on a protective claim have four options:
1. File an administrative appeal with the IRS within 30 days of the notice's issuance.
2. Request the IRS to reconsider the disallowance in light of the Quality Stores ruling.
3. Bring a lawsuit against the IRS immediately.
4. Reserve the right to file suit in federal court (i.e., wait and see).
The first and second options appear unlikely to succeed. The fourth option may make sense for many taxpayers because one or more taxpayers outside the Sixth Circuit are likely to bring suit against the IRS so that the issue is brought before the courts in other circuits. Plus, Quality Stores itself could go to the Supreme Court. So taxpayers not filing an immediate suit themselves can wait for these cases to develop. Employers have up to two years from the date of an IRS notice of disallowance to file suit in federal court to seek an order overturning the IRS's decision. Taxpayers who have already had a protective claim denied may be nearing the end of the two-year window, but it is possible to file for a two-year extension.
If the IRS appeals Quality Stores to the Supreme Court, it would likely have to acknowledge that CSX would no longer be settled law. Under those circumstances, it is unknown whether the IRS would then continue to deny refund claims outside the Sixth Circuit.
Filing a FICA refund claim
FICA protective refund claims may be filed without notifying the affected employees. To file an actual refund claim for the employer's share of FICA tax, however, the employer must first make a reasonable attempt to notify the affected employees of the availability of the refund and offer to file a refund claim on behalf of the employees for the employees' share of FICA tax. To file a refund claim on behalf of an employee, the employee must provide the employer with a written statement certifying that the employee will not file a refund claim directly with the IRS and also provide written consent for the employer to file the refund claim on the employee's behalf. If employees cannot be located and/or the employees do not provide their written consent, the employer may file a refund claim for just the employer's share of FICA tax.
Employee wage information must be preserved. As it may take several years for the appeals process to conclude, employers should take steps now to maintain and preserve wage information necessary to file actual refund claims.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
