04.06.10

Court Declares Certain Severance Payments FICA Exempt

A February U.S. District Court decision presents a potential refund opportunity for employers who have withheld and submitted Federal Insurance Contributions Act (FICA) taxes from severance payments. In United States v. Quality Stores, Inc., 105 AFTR 2d 2010-533 (W.D. Mich. 2010), the court upheld a Bankruptcy Court’s decision that severance payments made by a bankrupt retailer to its employees pursuant to pre- and post-bankruptcy petition severance programs were not wages for purposes of FICA taxation because the payments fell within the Internal Revenue Code (IRC) Sec. 3402(o)(2) exception to wages for supplemental unemployment compensation benefits.

Background

While it is certain that severance payments are subject to federal income tax withholding, there are differing opinions on whether severance payments are wages subject to FICA taxation. For income tax withholding purposes, the IRC defines supplemental unemployment compensation benefits (SUB) in IRC Sec. 3402(o)(2) as “amounts which are paid to an employee, pursuant to a plan to which the employer is a party, because of an employee’s involuntary separation from employment (whether or not such separation is temporary), resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions, but only to the extent such benefits are includible in the employee’s gross income.” IRC Sec. 3402(o)(1) prescribes that SUB payment “shall be treated as if it were a payment of wages by an employer to an employee for a payroll period.” The language “shall be treated as if it were a payment of wages” opens the door for debate as some take the position that this implies that SUB payments are not wages and others suggest that “shall be treated as if it were” does not otherwise imply that SUB payments are not wages.

In 2008, the U.S. Court of Appeals for the Federal Circuit took the latter position in and agreed with the IRS that SUB payments are wages and subject to FICA taxation unless they met other criteria provided in IRS Revenue Rulings to be excluded for FICA purposes.

The U.S. District Court for the Western District of Michigan, however, took the position that “shall be treated as if it were a payment of wages” implies that SUB payments are not wages and therefore not subject to FICA taxation. The District Court also ruled on the grounds that severance payments are intended to serve the same purpose as social security benefits, that severance payments should be viewed as wage-replacement social benefits, and not taxable remuneration for the employees’ services or wages.


Not All Severance Payments Are Made Equal

Not all severance payments are SUB payments. SUB is defined under IRC Sec. 3402(o)(2). It must be “pursuant to a plan…resulting…from a reduction in force, the discontinuance of a plant or operation, or other similar conditions…” Quality Stores, Inc. had filed for bankruptcy and the severance payments were made pursuant to severance programs. The facts and circumstances of that particular case were such that these severance payments were determined to meet the definition of SUB payments. Care should be taken to evaluate whether severance payments made were indeed SUB payments.

Actions Required - Filing Protective Claims

If your company has paid FICA taxes on severance payments that meet the definition of SUB payments, there is an opportunity to file refund claims as a protective measure. All quarterly payroll tax returns are deemed filed on April 15 of the following year and the statue of limitations is generally three years. Thus, to file any refund claims for 2006 your company would need to file a claim by April 15, 2010. To file a protective claim, a Form 941-X is filed for each quarterly tax return period still open. Refund claims may be filed for 2006, 2007, 2008 and 2009. It is important to note that there are differing opinions on whether severance payments are wages subject to FICA taxation. It is anticipated that the IRS will most likely appeal the district court’s decision or construe it narrowly to the facts in the case. The IRS is unlikely to pay out refunds until an appeals case is completed or Congress intervenes.

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