“Quality Stores” Decision Offers Social Security Tax Refund Opportunity on Severance Pay

“Quality Stores” Decision Offers Social Security Tax Refund Opportunity on Severance Pay
From the November 2010 Riker Danzig Tax and Trusts & Estates UPDATE

Employers experiencing reductions in force or layoffs ("RIFs") over the past several years may wish to consider filing claims for refunds of Social Security taxes (sometimes known as "FICA" or "payroll" taxes) paid in connection with certain severance benefits to terminated employees, based on a federal district court decision, U.S. v. Quality Stores, Inc., 105 AFTR 2d 2010-1110 (W.D. Mich., 2010).

Under the Internal Revenue Code of 1986, as amended (the “Code"), all compensation income constituting "wages" is subject to both federal income tax and FICA tax. The aggregate FICA tax liability (in the amount of 15.3% of taxable wages) is split between the employee and the employer at a rate of 7.65% each, and the employer paying such wages is obligated to withhold both income taxes and the employee's share of FICA taxes from the employee's paycheck. Additionally, the employer is obligated to pay its own share of FICA taxes at the time it forwards the employee's withheld taxes to the Internal Revenue Service.

In the Quality Stores case, the taxpayer-employer paid over $1 million in FICA taxes in connection with RIFs in which terminated employees were paid cash severance benefits under the terms of applicable severance plans. The taxpayer then challenged the application of FICA taxes to its payment of severance benefits, claiming that such severance payments qualified as "supplemental unemployment compensation benefits" ("SUB pay"), and were therefore explicitly exempt from FICA tax under the Code.

In deciding this case, the court addressed the IRS's longstanding narrow definition of SUB pay, developed through a series of published and private rulings dating back to the 1950s. These rulings established the IRS position that, in order for SUB pay to be exempt from FICA taxes, it must (a) be linked to the employee's receipt of state unemployment compensation, and (b) not be received in a lump sum.

The court in Quality Stores ultimately rejected this IRS position and held that the severance payments at issue in the case did not constitute "wages" for FICA tax purposes. The court's decision was largely based on Section 3402(o) of the Code, which defines SUB pay for FICA tax purposes 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 service … 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.

In the court's analysis, this language does not incorporate the IRS's more restrictive conditions to establishing SUB pay, and it therefore held that the severance payments made by the taxpayer to terminated employees were not subject to FICA taxes. The decision did not affect the fact that the severance payments were treated as taxable compensation income to the recipient-employees, nor did it alter the employer's obligation to withhold federal income taxes on such taxable severance pay.

The Quality Stores decision, if adhered to by other federal courts, would represent a significant liberalization of the definition of SUB pay for FICA tax purposes. As of today, however, the decision reflects only the views of a Michigan federal district court and will not necessarily be followed by other federal courts. Moreover, the government has not yet announced whether it will appeal the decision. Nevertheless, employers who have recently engaged in RIFs may wish to consider filing a protective refund claim for any FICA taxes paid on severance benefits to terminated employees during years not yet closed by the statute of limitations. For many employers, this could represent a substantial tax refund. In addition, pending further developments in this area, employers contemplating future RIFs may consider whether or not to pay and withhold FICA taxes on severance benefits payable in connection with such RIF, to the extent that such benefits can be characterized as SUB pay under the Quality Stores decision.