District Court Rules that Severance Pay Not Subject to Social Security Taxes

March 2010

Background

After nearly two years of believing the issue was settled, employers received news last month that certain severance benefits may not be subject to taxation under the Federal Insurance Contributions Act (FICA). In United States v Quality Stores, Inc., No. 1:09-cv-44 (W.D. Mich. Feb. 23, 2010), a decision affirming a Bankruptcy Court decision, the U.S. District Court for the Western District of Michigan highlighted the historical uncertainty regarding whether certain severance payments made to employees pursuant to an involuntary reduction in force were not “wages” that are subject to FICA taxation. In this instance, the court held that such payments were not subject to FICA, as they did not constitute wages.

Discussion Prior to bankruptcy, Quality Stores, Inc. (Quality Stores) maintained a chain of retail stores. Approximately 75 employees were laid off prior to bankruptcy proceedings. All remaining employees were terminated after the filing of a Chapter 11 petition. Severance payments were made to all employees terminated due to involuntary separation of employment pursuant to Quality Stores’ severance plans. The wages were reported on the Forms W-2 issued and the company withheld federal income tax and the employees’ share of FICA tax. FICA, codified in IRC sections 3101 through 3128, imposes a tax upon employees' wages to fund Social Security and Medicare benefits. Under IRC section 3121(a), "wages" are defined as "all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash." Compensation paid for current employees' services clearly falls into the FICA definition of wages, but what is not as obvious is whether severance paid to former employees falls into that same category.

Quality Stores sought a refund for the FICA taxes paid with regard to the severance while in bankruptcy. Although the severance payments were not related to the recipients' eligibility for state unemployment benefits, as required by Rev. Rul. 90-72, 1990-2 CB 211, the District Court ruled that the severance payments did not constitute wages for FICA purposes because they fell within the IRC section 3402(o)(2) exception to wages for supplemental unemployment benefits (SUB). The Bankruptcy Court relied in part on a similar case, CSX Corporation Inc. v. United States, 52 Fed. Cl. 208 (2002).

The U.S. Court of Appeals for the Federal Circuit later reversed that decision in CSX after a review of the lower court’s decision. The Federal Circuit held that involuntary severance payments are wages for FICA purposes in CSX Corporation v. United States, 518 F.3d 1328 (Fed. Cir. 2008). Based on the appeals court decision in CSX, the United States then moved for a reconsideration of the Bankruptcy Court’s decision in Quality Stores, which was granted.
  The debtors made severance payments pursuant to severance plans to employees terminated before and after the institution of the bankruptcy proceeding. Payments were made as a result of employees’ involuntary termination that resulted directly from a reduction in force or the discontinuance of a plant or operation. Employees’ severance payments were included in their gross income, Quality Stores reported the severance payments as wages on the Forms W-2 issued to the employees, and federal income tax and the employees' share of FICA tax were withheld from the severance payments.

Under the pre-bankruptcy severance plan, senior executives received 12 – 18 months of severance pay, and all other employees received one week of severance pay per full year of service. Under the post-bankruptcy severance plan, officers received 6 – 12 months of severance; full-time salaried and hourly employees with at least two years of service received one week of severance pay for each full year of service, up to a maximum of 10 weeks for salaried employees and five weeks for hourly employees; and employees with fewer than two years of service received one week of severance pay.

Quality Stores claimed that IRC section 3402(o), applicable to federal income tax withholding, extends income tax withholding to certain payments other than wages, including SUB payments, and applies to the involuntary separation payments made to the employees. The District Court reasoned that a 1983 amendment to IRC section 3121(a) “decouples” the exclusion from wages for income tax withholding purposes from the exclusion from wages for FICA tax purposes, but found that “no such regulations have been promulgated to distinguish between the ’wage’ exclusions under consideration,” and ruled that the income tax withholding exclusion from wages for SUB payments also applied to FICA tax. It concluded the SUB payments should be viewed as wage-replacement social benefits, not taxable remuneration for an employee's services or wage, which therefore exempts SUB payments from FICA.

How to take action

With many businesses making severance payments to employees terminated as a result of difficult economic conditions, the FICA tax savings could be significant. Although the IRS will almost certainly appeal the decision in Quality Stores, employers should consider filing protective refund claims for FICA tax on severance payments made in 2006 because the statute of limitations is set to expire on April 15, 2010. A decision to file a protective claim for future years may be deferred at this time. If properly filed, a protective refund claim extends the statute of limitations for a minimum of two years while other parties settle their cases in court.

We recommend that employers continue to treat ongoing severance payments as wages for FICA tax purposes, and continue to file protective claims for these taxes until the likely appeal is resolved. This is important because, if the IRS prevails in its likely appeal of the Quality Stores decision, and an employer did not treat new severance payments as wages for FICA tax purposes, the employer’s and former employees’ FICA taxes will be owed to the IRS by the employer, and it will be difficult, if not impossible, to collect the employees’ halves from terminated employees after their severance has been paid in full.