Global Tax Alert | 2 October 2013

US Supreme Court agrees to hear Quality Stores case on whether severance is subject to FICA

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On October 1, 2013, the United States Supreme Court granted a writ of certiorari in U.S. v Quality Stores, Inc. (In re Quality Stores, Inc.), cert. granted No. 12-1408. Accordingly, the case has been added to the Court's docket for consideration during the 2013-2014 term. The effect of this grant is that the previous opinion of the US Sixth Circuit Court of Appeals will be reviewed by the Court and its ultimate decision will apply to all employers across the United States.

In Quality Stores, 693 F.3d 605 (6th Cir. 2012), the Sixth Circuit held that there is no FICA tax due on severance pay that qualifies as supplemental unemployment benefits (SUB payments). However, the Federal Circuit's opinion in CSX Corp. v United States, 518 F.3d 1328 (Fed. Cir. 2008) holds the opposite (i.e., employers and employees each owe FICA tax on severance payments). In light of the split authority in the these Circuits, and because of the size of the potential FICA tax refund obligations, the Internal Revenue Service requested certiorari of the Quality Stores case on May 31, 2013.

If Quality Stores is upheld, the case could yield billions of dollars in FICA tax refunds to employers and their former employees for tax years during which severance payments were made and for which protective FICA tax refund claims were filed. If the Sixth Circuit's decision is reversed, the holding in the CSX case will remain and severance will continue to be subject to FICA for both employers and employees.

Quality Stores case summary

In the period preceding its bankruptcy petition (the pre-petition period), Quality Stores closed numerous stores and distribution centers and consequently terminated approximately 75 corporate employees. Under the prepetition severance plan, these employees received severance payments that were paid in accordance with the normal payroll period. After the petition date for filing voluntary Chapter 11 bankruptcy (the post-petition period), the remaining stores and distribution centers were closed and all remaining employees were terminated. Severance payments made under the post-petition severance plan were paid in a lump sum. For both the pre-petition and post-petition severance pay plans, payment of the severance was not linked to the receipt of state unemployment benefits, nor were they attributable to the provision of any particular services. At issue was whether the severance paid under both the pre-petition and post-petition plans was exempt from Social Security and Medicare (FICA) taxes as a SUB plan payout as defined in Section 3402(o)(2).

In Quality Stores, Inc. v. U.S., 383 B.R. 67 (Bankr. W.D. Mich. 2008), the bankruptcy court held that payments Quality Stores made to its employees upon terminating their employment involuntarily due to business cessation constituted SUB payments that are not taxable as wages for FICA. On appeal, the district court affirmed. 424 B.R. 237 (W.D. Mich. 2010). The district court held that all of the severance payments made to the laid off workers were in the nature of a SUB benefit and exempt from FICA under Section 3402(o)(2) without regard to Revenue Ruling 90-72 (1990-2 C.B. 211). Under Revenue Ruling 90-72, the IRS takes the position that, for severance pay to be exempt from wages subject to federal income tax withholding and FICA, it must be paid under a SUB plan and under such plan, severance pay is linked to the receipt of state unemployment compensation and cannot be paid in a lump sum.

In arriving at its conclusion, the Sixth Circuit viewed the legislative history of how wages are defined for both FICA and federal income tax withholding purposes. It concluded that Congress was referring only to federal income tax withholding, not FICA, when it stated that severance pay was required to be supplemental to unemployment

The Court further held that, despite "other plausible inferences that might be drawn," the statute concerning the FICA tax treatment of SUB payments may be ambiguous. When a statute is silent or ambiguous, the question posed by the Court is whether the agency's (e.g., the IRS's) interpretation is based on a permissible construction of the statute. In this review, the Sixth Circuit considered the title of Section 3402(o), "Extension of withholding to certain payments other than wages." The phrase, "other than wages," supported the Court's conclusion that Congress knew that it was extending federal income tax withholding to payments "other than wages" when it enacted Section 3402(o). Thus, relying also on Rowan Cos. v. U.S., 452 U.S. 247 (1981), to read the definitions of "wages" found in the FICA and federal income tax statutes consistently, the Court determined that Congress characterized SUB payments as "non-wages" for purposes of both FICA and income tax withholding. Accordingly, the subject payments made by Quality Stores qualify as SUB payments under Section 3402(o) and such payments are not "wages" for purposes of FICA taxation.

EY insights

The IRS has consistently denied protective claims for FICA refunds outside of the Sixth Circuit and it is not currently acting upon claims filed by employers from within the Sixth Circuit. We expect this treatment to continue until the Supreme Court renders its decision in 2014.

At this time, all employers with involuntary employee terminations during the years currently open under the statute of limitations (i.e., 2010 through current) should consider filing protective FICA tax refund claims in order to have as many protective claims filed as possible, prior to any potential legislative or IRS actions to limit the potential refunds in the event the Quality Stores case is upheld. For example, the IRS could issue regulations specifically providing that FICA applies to SUB payments.

There is a question whether these would be retroactive regulations on this matter. Section 7805(b) gives the Secretary of the Treasury the discretion to limit the retroactive effect of treasury rules or regulations. The IRS has previously issued regulations regarding whether payments to medical resident employees were subject to FICA, but those regulations were written after litigation on the issue. In that situation, IRS did not apply the regulations retroactively. In the current situation, should regulations be issued, it is uncertain whether they would be retroactively applied. In any case, as IRS faces continuous litigation on many of the claims that have already been filed, it may want to offer settlements to claimants, as it did for the medical resident FICA claimants.

For additional information with respect to this Alert, please contact the following:

Employment Tax Services Group
  • Pete Berard
    +1 212 773 4084
Federal Employment Tax Controversy Group (a subgroup of TCRMS)
  • Mary Gorman
    +1 202 327 7644
  • Tom Meyerer
    +1 202 327 8380
  • Debbie Spyker
    +1 720 931 4321