Affirming a decision in the lower court, the Sixth Circuit Court of Appeals ruled recently in a controversial case that severance payments made to employees are exempt from federal payroll taxes. (U.S. v. Quality Stores, Inc., CA-6, No. 10-1563, 9/7/12)

As a result, the government must refund over $1 million in payroll taxes that were improperly collected from the employer and employees.

In the wake of this case, an employer may want to file a protective refund claim for open tax years if it previously paid the full amount of payroll taxes on severance payments. (There is a statute of limitations on filing.)

"Although Quality Stores collected and paid the FICA tax, it did not agree with the Internal Revenue Service (IRS) that the severance payments constituted wages for FICA purposes. Quality Stores took the position that the payments made to its employees pursuant to the plans were not wages but instead constituted SUB payments that were not taxable under FICA."


"The payments Quality Stores made to its employees ... qualify as SUB payments under I.R.C. Section 3402(o). Because Congress has provided that SUB payments are not 'wages' and are treated only as if they were 'wages' for purposes of federal income tax withholding, such payments are not 'wages' for purposes of FICA taxation."

-- Sixth Circuit U.S. Court of Appeals in Quality Stores, Inc. 

Nevertheless, don't expect the IRS to throw in the towel on this issue. Due to conflicting decisions in other courts, the IRS is likely to appeal this latest decision.

Basic Tax Rules

For 2012, an employee must pay a 4.2 percent OASDI tax on the amount of wages up to the "Social Security wage base" of $110,100 and a 1.45 percent Medicare tax on all wages. The employer must also pay its corresponding share of these payroll taxes. Beginning in 2013, the 4.2 percent OASDI tax rate will revert to a 6.2 percent rate, barring any extension of this tax provision by Congress. This was the rate in effect prior to a one-year tax break initially enacted for 2011 only and subsequently extended through 2012.

In general, wages that are subject to income tax withholding are also treated as wages for payroll tax purposes. However, certain types of payments to employees are excluded from the definition of "wages" for federal income tax purposes, including Supplemental Unemployment Compensation Benefits (SUB). To qualify as SUB, payment must be:

1. Made to an employee;

2. Pursuant to an employer's plan;

3. Due to 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.

Because severance payments are clearly wages for federal income tax purposes, the IRS has consistently maintained that any severance payments made to terminated workers are subject to payroll taxes. Traditionally, the courts have gone along with this point of view. But now, the Quality Stores case turns things upside down.

Facts of the Recent Case

Quality Stores was the largest agricultural-specialty retailer in the country serving farmers, hobby gardeners, skilled trade persons, and do-it-yourself customers. The retail chain encountered financial difficulties and closed 63 stores and nine distribution centers. It also terminated the employment of approximately 75 employees at its corporate offices. In 2001, an involuntary Chapter 11 bankruptcy petition was filed against the retail outfit. Quality Stores then closed more than 300 stores and its remaining distribution centers. Finally, it discharged all the employees who were still left on the payroll.

The terminated employees received severance in amounts based on their job grade, management level, time on the job and their date of termination. Initially, Quality Stores reported the severance payments as wages on employees' W-2s, withheld the appropriate amount of income taxes and payroll taxes, and paid its share of the payroll taxes. However, in 2002, it filed refund claims for overpaid payroll taxes totaling $1.125 million, plus interest, on the severance payments.

The District Court in Michigan ruled the severance payments should not be characterized as wages for payroll tax purposes. It said that the payments were in the nature of SUB payments. The District Court also referenced a landmark Supreme Court case (Rowan Companies, Inc., 452 US 247, 1981) in its decision.

In the Rowan case, the Supreme Court determined that Congress intended a uniform definition of "wages" for income tax and payroll tax purposes. Subsequently, Congress passed a "decoupling rule" separating the imposition of payroll taxes from the treatment of income taxes in existing regulations.

Now the Sixth Circuit Court of Appeals has sided with the District Court. It found that Congress has expressly provided that any payment that meets the statutory definition of a SUB payment is treated as if it were a payment of wages. According to the court, Congress did not consider SUB payments to be wages, but allowed their treatment as wages in order to facilitate federal income tax withholding. Because SUB payments are not wages, but are treated as if they were wages for federal income tax withholding, SUB payments are also not wages for payroll tax purposes.

The court also rejected the IRS claim that the Rowan case is no longer controlling. When Congress enacted the decoupling rule, it did not provide that wages must be treated differently for purposes of federal income tax withholding and payroll taxes. Instead, the amendment was intended to allow the IRS to issue regulations to provide for different exclusions from wages under FICA than under the income tax withholding laws. The IRS has not issued any regulations under the decoupling amendment.

Bottom line: The Sixth Circuit Court said the payments were SUB payments that aren't subject to payroll taxes. It is noteworthy that this new decision conflicts with another Federal Court of Claims decision (CSX Corp. v. U.S., CA- FC, 101 AFTR2d 2008-1120) made in 2008.

Lessons to Be Learned

As evidenced by the new case, the money involved can be substantial. Even if your small company doesn't have millions at stake, you might save tens or even hundreds of thousands of tax dollars based on the latest ruling.

Be aware that the IRS hasn't conceded defeat on this issue and the case may eventually work its way up to the U.S. Supreme Court. In the meantime, an employer in similar circumstances may want to file a protective claim to preserve the statute of limitations on payroll tax refund claims for open years and later file a supplementary claim with the requisite employee consents and calculations. The due date for making a protective claim is three years from April 15 of the year following the year in which the severance payments were made. For example, if payroll taxes were paid in 2009, the protective claim should be filed by April 15, 2013.

Until this matter is completely resolved, employers are generally advised to continue withholding FICA taxes on separation payments made in connection with the an involuntary termination of employees. Consult with your tax adviser or attorney about your situation.

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