Appeals Court Excludes Certain Severance Packages from FICA Tax Liability

Social Security Card A federal appeals court recently determined that supplemental unemployment benefit payments made as part of severance packages do not constitute income, and do not trigger a liability for FICA withholding. The ruling in United States v. Quality Stores granted a $1 million refund to a bankrupt agricultural retailer that paid FICA taxes on its severance payments to the employees it terminated when the chain closed.

Creditors of Quality Stores, a chain of financially struggling farming and gardening stores, filed an involuntary bankruptcy petition late in 2001. The chain ultimately closed all operations and terminated all employees. The store made severance payments to those employees whom it involuntarily dismissed. Quality reported the payments as W-2 income and withheld federal income tax, along with both employer’s and employee’s shares of FICA tax, even though the company did not believe the packages constituted income. Quality followed up by requesting a refund from the IRS for the FICA tax payments. The IRS did not act, and the store took its claim to the bankruptcy court.

The bankruptcy court concluded that the packages were supplemental unemployment benefit (SUB) payments, not income, and ordered a full refund. The government appealed, but both the federal District Court and the 6th Circuit Court of Appeals affirmed the lower court. The appeals court noted that, Congress, in enacting statutes regarding these payments, expressly stated that a SUB payment “shall be treated as if it were a payment of wages by an employer to an employee for a payroll period.” The logical conclusion, the court reasoned, was that SUB payments were not actually wages. The court also went back to 1969, citing the legislative history of 26 USC 3402(o), which stated that SUB payment “do not constitute wages or remuneration for services.” SUB payments, the court concluded, were non-wages that Congress mandated employers treat as wages solely for the purpose of income tax withholding, in order to alleviate the burden on employees.

The appeals court subsequently pointed out that the definitions of “wages” from the income tax withholding statutes and the FICA statutes were nearly identical, leading to the conclusion that, because SUB payments were not wages under the income tax withholding rules, they must be non-wages under FICA, as well. The Quality decision adds an additional wrinkle to an already complex issue, as the Federal Circuit Court of Appeals, in CSX Corp. v. United States, reached the opposite conclusion just four years earlier. The 6th Circuit, in its concluding paragraph in Quality, noted that “the Supreme Court may ultimately provide us with the correct resolution of these difficult issues under the law.”

While the Quality decision may only serve as controlling law only in Michigan, Ohio, Kentucky and Tennessee, employers everywhere may want to consider their options. Factoring in similar suits (with eight current actions in the federal courts having a combined value of almost $120 million,) along with similar claims still pending before the IRS, the total value of the refund demands exceeds $1 billion, according to PricewaterhouseCoopers. The split between the 6th and Federal Circuit courts may push the Quality case up to the U.S. Supreme Court, and if the high court agrees with the 6th Circuit, then employers nationwide would be entitled to similar refunds.

The tax attorneys at Samuel C. Berger, P.C. and the CPAs at S.C. Berger, P.C. can help businesses throughout New York and northern New Jersey with a variety of issues facing employers, including income tax withholding and FICA taxes. To consult our attorneys and CPAs, contact us online or call (201) 587-1500 or (212) 380-8117.

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