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Protective FICA Claim For Severance Payments

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April 2010


The application of FICA tax to severance pay in connection with certain events such as a reduction in force or plant closing has been hotly contested in the courts for a number of years. With the recent economic decline, many companies have had reductions in force and plant closings and paid severance to terminated employees. Most likely, those companies paid both the employer’s and employee’s share of FICA on those payments. The Internal Revenue Service has been successful in defending the government’s position that such payments are wages subject to FICA tax.

Now, however, the United States District Court for the Western District of Michigan reached a taxpayer-favorable result on the application of the FICA tax to severance payments when it chose not to follow a 2008 ruling by the United States Court of Appeals for the Federal Circuit in CSX Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008). The court ruled that the bankruptcy court in United States v. Quality Stores Inc. correctly determined that payments a company made to employees as part of a company’s severance program were not subject to FICA tax. In re Quality Stores Inc., No. 1:09-cv- 44 (Feb. 23, 2010).

As background, the Service applies a set of strict standards for a taxpayer to treat severance pay as exempt from FICA tax. See Rev. Rul. 90-72. Thus, under these standards, severance pay is generally considered wages for such purposes. However, section 3402(o) treats the payment of certain supplemental unemployment compensation benefits (referred to as “SUB pay”) “as if it were a payment of wages” for income tax withholding purposes.

Taxpayers have argued that the inference to be drawn from section 3402(o) is that SUB pay is generally not treated as wages for employment tax purposes; otherwise, the “as if it were” language would not have been necessary. There is no corollary provision in section 3121 to exempt such payments from FICA tax but the court in Quality Stores applied the standards set forth in section 3402(o) to exempt SUB pay from FICA taxes.

Note that section 3402(o) has three requirements:

  1. amounts are paid to an employee pursuant to a plan
  2. as a result of an involuntary separation from employment
  3. related directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions.

We expect that many companies will be able to meet these requirements as a result of their recent severance payments.

We expect that the Service will likely appeal this case. However, because the statute of limitations expires three years after such amounts are reported (for example, April 15, 2010, for the 2006 calendar year) we are recommending that employers file protective refund claims to prevent loss of benefits due to the statute running. Companies should quantify the potential refunds and should file such a claim if such amounts are meaningful.

Update on FICA Refund - Government Appeals United States v. Quality Stores

On April 27, 2010, the United States, not surprisingly, filed its notice of appeal of the district court’s decision in Quality Stores, asking the United States Court of Appeals for the Sixth Circuit to reverse the lower court’s decision. Based on the lower court’s decision in CSX and on the Quality Stores decision, many employers that downsized filed claims or protective claims for a refund of FICA taxes based on the court’s application of the exception for “supplemental unemployment benefits” to severance payments.

The Service has recently denied refund claims and protective refund claims based on the Federal Circuit’s reversal of the Court of Federal Claims in CSX Corp. More recent refund claims based on the enhanced arguments of Quality Stores have also been denied, citing the CSX decision.

Although the Service’s refund claim denial letter is short and generated with little explanation, it is clear that taxpayers have 30 days in which to appeal, sending the case to IRS Appeals. If, after the IRS Appeals Office considers the refund claim, the taxpayer and the Service remain unagreed on the refund claim, the taxpayer (or employer) has two years from the date of the taxpayer’s first denial in which to file a refund lawsuit in either the United States Court of Federal Claims or the local United States district court.

The decision of the United States Bankruptcy Court and United States District Court in Quality Stores may bolster taxpayers’ arguments in support of excluding downsizing severance payments from “wages” for FICA tax purposes. Taxpayers (and employers) must be mindful of the time within which taxpayers must make refund claims or protective refund claims and, if such claims are denied, what options are available to them.

Material Discussed in this Alert is meant to provide general information and should not be acted on without obtaining professional advice tailored to your firm's individual and specific needs. Any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.This information is for general guidance only and is not a substitute for professional advice.

Related Team Member(s)
Craig Eaton
Lead Partner — Tax
(978) 557-5360
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