6th Circuit: Severance Pay Not Taxable Under FICA

by Jerry Meek

In a stunning upset to the IRS and a sharp break with the Federal Circuit, the 6th Circuit has held that “supplemental unemployment compensation benefits” (or SUB benefits) are not taxable under FICA.

In In re Quality Stores, Inc. No. 10-1563 (6th Cir. September 7, 2012), the taxpayer, a Chapter 11 debtor, brought an adversary action in bankruptcy seeking a refund of approximately $1 million in taxes paid, on behalf of itself and certain employees, under FICA. The taxes arose out of severance payments made to employees pursuant to a plan to reduce the workforce and discontinue operations.

In Revenue Ruling 90-72, the IRS held that SUB payments would only be excluded from the definition of “wages” for FICA purposes if, among other things, the payments are: (1) linked to the receipt of state unemployment compensation benefits (and hence “supplemental” to those benefits); and (2) not provided in the form of a lump sum.

In CSX Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008), CSX paid separation allowances, in connection with workforce reductions, in the form of lump-sum payments to some of its employees. The payments were made irrespective of whether the employee applied for or received unemployment compensation. Noting that the payments did not meet the requirements of Revenue Ruling 90-72, the Federal Circuit held that the payments constituted “wages” for purposes of FICA and were therefore taxable.

As in CSX Corp., the payments at issue in Quality Stores consisted of lump-sum payments, made to employees regardless of whether they applied for or received unemployment compensation. Adopting the exact same statutory interpretation earlier rejected by the Federal Circuit, the 6th Circuit held that the payments were not taxable under FICA.

I.R.C. § 3402(o) provides that, for withholding purposes, a SUB payment “shall be treated as if it were a payment of wages by an employer to an employee for a payroll period.” According to the 6th Circuit, the adoption of § 3402(o) is a recognition that Congress did not consider SUB payments to be “wages” for income tax purposes. (Otherwise, it would be unnecessary to specify that they should be treated as wages for income withholding purposes.) In Rowan Cos. V. United States, 452 U.S. 247 (1981), the Supreme Court held that Congress intended the term “wages” to carry the same meaning for purposes of both federal income tax withholding and FICA taxes, leading the 6th Circuit to conclude that, if Congress did not intend for SUB payments to be wages for income tax purposes, it must not have intended them to be wages for FICA purposes. Significantly, § 3402(o)(2)(A) defines SUB benefits without regard to whether the pay is linked to unemployment compensation or paid in a lump sum.

The 6th Circuit’s decision is only binding in that circuit. As a result, the IRS will continue to assert that taxpayers domiciled outside of Kentucky, Ohio, Michigan, and Tennessee must pay FICA taxes on any severance payment that does not meet the requirements of Revenue Ruling 90-72. Taxpayers in other circuits should file protective refund claims, using Form 941-X, within the statute of limitations (generally 3 years from the April 15th following the year the original Form 941 was filed). If the claim is denied, taxpayers should either timely file a refund suit or enter into an agreement with the IRS extending the time for such a suit, allowing time for the issue to be resolved by either the Supreme Court or other Circuit Courts.