In a long-awaited decision, the U.S. Court of Appeals for the Sixth Circuit held in United States v. Quality Stores, Inc., September 7, 2012, that certain dismissal payments were Supplemental Unemployment Compensation Benefits (SUB) exempt from FICA taxes. This decision creates a clear split with the U.S. Court of Appeals for the Federal Circuit’s decision in CSX Corporation v. United States (518 F.3d 1328 (Fed. Cir. 2008)), which followed an Internal Revenue Service (IRS) Revenue Ruling that significantly narrowed the criteria for determining whether certain separation payments qualify as SUB pay. For certain employers that have made significant reductions in force payments in open years, the Quality Stores decision could lead to significant refunds of FICA tax.
The Internal Revenue Code excludes any SUB payments to employees from the definition of “wages” for federal income tax purposes. The statute essentially sets forth two requirements in order for severance or dismissal payments to constitute SUB pay. The amounts must be paid to an employee:
- Because of an employee’s involuntary separation from employment
- Resulting directly from a reduction in force, the discontinuance of a plant or other similar conditions (IRC §3402(o)(2)(A).)
Based on the Sixth Circuit decision in Quality Stores, and the reasoning of the lower court decision in CSX (reversed by the Federal Circuit), it could be argued that these are the sole criteria to also exempt such payments from FICA and FUTA taxes. However, the IRS in Rev. Rul. 90-72 (1990-2 C.B. 211) significantly narrowed the criteria for determining whether such payments will qualify as FICA/FUTA-exempt payments. The IRS requires that separation payments not be made as a lump sum, that they be specifically designed to supplement state unemployment benefits and that the individual satisfies the requirements to receive state unemployment benefits.
The Sixth Circuit disagreed with the Federal Circuit, concluding:
“While the Supreme Court may ultimately provide us with the correct resolution of these difficult issues under the law as it currently stands, only Congress can clarify the statutes concerning the imposition of FICA tax on SUB payments. Our role is to interpret the statutory law as it presently exists, and we have done that today.”
In a series of informal remarks on September 14, 2012, at the American Bar Association’s Section of Taxation Joint Fall CLE Meeting, a knowledgeable spokesperson from the IRS Office of Chief Counsel advised that, outside of the Sixth Circuit, the IRS maintains its previous position under Rev. Rul. 90-72 regarding the employment tax treatment of SUB pay. The IRS is still deciding whether to seek a rehearing by the Sixth Circuit, or to request certiorari to the Supreme Court in response to the recent decision in Quality Stores.
Consider Filing a Protective Claim Now to Preserve Refund Opportunity
Although filing a complete refund claim can be burdensome from an administrative perspective, 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 and later file a supplementary claim with necessary employee consents and exact calculations. 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.
To preserve the statute for FICA refund claims already disallowed by the IRS (many have simply been held in abeyance by IRS), made in prior years, employers need to review the dates for the IRS notices of disallowance carefully, in order to ensure they preserve the period to bring a suit for refund against the IRS.
Continue Withholding FICA Taxes
Until this controversy is resolved, employers are advised to continue withholding FICA taxes on separation payments made in connection with the present or future involuntary termination of employees, which do not meet the strict Rev. Rul. 90-72 definition for exemption.