United States: Severance Payments May Not Be Subject to FICA Tax

As corporate downsizing becomes more commonplace in today's challenging business environment, severance payments to departing workers are under more scrutiny. It is well established that such severance payments are included in workers' gross income and subject to federal income tax withholding. But whether such severance payments are wages for purposes of the Federal Insurance Contributions Act has become a controversial issue over the years. Much of the debate stems from the intertwined and complex history of the federal income tax withholding and the FICA tax provisions.

Last year, the issue came to a head when the U.S. Court of Appeals for the Sixth Circuit, in United States v. Quality Stores, 110 AFTR 2d 2012-5827 (6th Cir. 2012), upheld the bankruptcy court's decision that payments made to employees upon terminating their employment due to business cessation constituted supplemental unemployment compensation benefits (SUB payments) and were not taxable as wages for purposes of FICA tax. This holding caused a split in the circuits because the U.S. Court of Appeals for the Federal Circuit in 2008 reversed a similar holding in CSX v. United States, 101 AFTR 2d 2008-1120 (CA Fed Cir. 2008). As a result of the Sixth Circuit's decision, employers nationwide, but specifically those employers from the Sixth Circuit, filed refund claims for FICA taxes paid on severance payments in recent years. More importantly, the U.S. Supreme Court on Oct. 1 agreed to review the Sixth Circuit's decision to resolve the circuit split. Pending the Supreme Court's decision, the Internal Revenue Service has suspended all action on refund claims submitted by employers from the Sixth Circuit, which are estimated to be approximately $127 million.

Congress imposed the FICA tax on employee wages to fund the Social Security and Medicare programs. The tax is levied on both the employer and the employee. The employer generally collects the employee's share by deducting the tax from wages as they are paid to the employee and simultaneously contributes the employer's share of the matching tax. For purposes of FICA tax, the term "wages" means all remuneration for employment, including cash value of all remuneration (including benefits) paid in any medium other than cash. SUB payments are neither included in, nor excluded from, the definition of "wages" for purposes of FICA tax. The IRS has consistently taken the position that payments made to employees upon the termination of their employment constitute wages for purposes of FICA tax.

Historically, the concept of SUB payments first appeared in the 1950s, evolving from the demands by labor unions for employers to supplement state unemployment compensation for employees who were laid off. For those supplemental payments to be effective, the payments needed to be excluded as wages, because certain states would not provide unemployment benefits if employees continued to earn wages from their employers. The IRS, through a series of Revenue Rulings, specifically carved out certain SUB payments from the definition of wages for purposes of FICA tax. However, for this exclusion to apply, the payments must meet the following requirements: (1) the payments are made following the involuntary separation of the employee from the employer's workforce; (2) the payments are designed to supplement state unemployment benefits; (3) the payments are not made in a lump sum but rather periodically for the duration of the former employee's unemployment; (4) the level of benefits depends on the employee's seniority and is not attributable to the rendering of any particular services; and (5) no employee has any interest in the fund from which the benefits are paid until the employee is eligible to receive benefits from that fund.

The Federal Circuit in CSX declined to expand the exclusion of SUB payments as wages for purposes of FICA tax beyond the specific exclusion set forth by the IRS in its rulings. In contrast, the Sixth Circuit held that SUB payments to terminated employees were not subject to FICA tax even when they were not based on state unemployment benefits and were paid in lump sum. In so holding, the Sixth Circuit declined to adopt the IRS's definition of SUB payments set out in its rulings, and instead applied the statutory definition of SUB payments provided by Congress in Section 3402(o)(2)(A) of the Internal Revenue Code of 1986, as amended.

The definition of SUB payments in Section 3402(o)(2)(A) of the code may be parsed into five separate elements: (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. Even though Congress provided this definition of SUB payments for federal income tax withholding and not for purposes of FICA tax, the Sixth Circuit applied the definition in Quality Stores where FICA tax was at issue. The Sixth Circuit justified its application of the statutory definition of SUB payments to a FICA tax issue by reasoning that the definition of wages for purposes of federal income tax withholding and FICA tax were nearly identical. Thus, a payment that is excluded as wages for purposes of federal income tax withholding would also be excluded as wages for purposes of FICA tax.

Section 3402(o)(1) of the code provides, in relevant part, that any SUB payments to an individual will be treated as if they were a payment of wages by an employer to an employee. The FICA tax provisions do not include a similar inclusion provision. Through negative reasoning, the Sixth Circuit concluded that SUB payments as defined by Section 3402(o)(2)(A) are not wages for purposes of either federal income tax withholding or FICA tax. Nonetheless, SUB payments are subject to federal income tax withholding because of the inclusion provision of Section 3402(o)(1). Since a similar provision does not exist for FICA tax purposes, such SUB payments are not subject to FICA tax.

Before the Sixth Circuit decision, the IRS had followed the Federal Circuit's ruling in CSX and disallowed employers' refund claims for FICA taxes paid on SUB payments that did not meet the requirements set forth in the Revenue Rulings. Until the U.S. Supreme Court resolves this issue, employers should take steps to protect their refund claims. Any employers that have made recent SUB payments and paid FICA taxes should consider filing a protective claim for refund on Form 941-X, Adjusted Employer's Quarterly Federal Tax Return or Claim for Refund, which will reduce the likelihood that a refund claim becomes barred by the statute of limitations before the U.S. Supreme Court's decision is issued. Employers within the Sixth Circuit—Kentucky, Michigan, Ohio and Tennessee—should note that the IRS has suspended action on administrative refund claims within that circuit and, thus, no IRS determinations will be issued until the U.S. Supreme Court issues its decision. Also, any employers that filed a refund claim for FICA taxes paid on SUB payments and received a notice of disallowance from the IRS should check the time remaining on their two-year limitations period to file a suit. If the two-year limitations period is approaching, the employers should seek to file Form 907, Agreement to Extend the Time to Bring Suit, to extend the time to bring suit for the recovery of FICA taxes. Based on the Sixth Circuit's decision, the IRS has agreed to sign Form 907 for certain employers whose refund claims were disallowed.

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