By Ken Berry
Do you remember those payroll tax payments your client made a few years ago on severance packages for workers it was forced to lay off or fire? It's much more than "water under the bridge." According to a new groundbreaking case in the Sixth Circuit Court, your client could be in line for a big tax refund (United States v. Quality Stores, Inc., CA-6, 110 AFTR2d 2012-6253, 9/7/12).
But don't think this is a slam dunk. The IRS isn't throwing in the towel by any means.
Here are the key facts of the new case:
A large retail operation, Quality Stores, Inc., went bankrupt and eventually closed all its stores. The company paid severance to workers and withheld FICA and federal income taxes in addition to the payroll taxes it paid for the employees. But then it filed a claim for a refund of more than $1 million representing the employer and employee portions of the payroll taxes.
When the IRS denied the claim, Quality Stores sought relief in bankruptcy court. The court found that the severance payments constituted supplemental unemployment compensation benefits (SUB payments) and therefore shouldn't be treated as wages for FICA purposes. It authorized the refund and a district court in Michigan agreed.
In the decision, the district court referred to a landmark US Supreme Court case (Rowan Companies, Inc., v. United States, 452 US 247, 1981). The top court said in Rowan that Congress intended a uniform definition of "wages" for income tax and payroll tax purposes. Note that Congress subsequently enacted a "decoupling rule" separating the treatment of payroll taxes from income taxes.
Despite this setback, the IRS refused to concede and appealed to the Sixth Circuit Court. The latest decision turned on whether the payments were SUB payments, and if they were, whether or not they were also wages for purposes of FICA withholding.
To make this determination, the Court reviewed the five-part test found in the tax code (IRC Sec. 3402(o)(2)(A)), which states that a SUB payment must be:
- Made to an employee;
- Pursuant to an employer's plan;
- Due to an employee's involuntary separation from employment, whether temporary or permanent;
- Resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions; and
- Included in the employee's gross income.
The Sixth Circuit ruled that severance payments were SUB payments. Furthermore, it said that Congress did not consider SUB payments to be wages, but it allowed them to be treated as wages to facilitate federal income tax withholding. Because SUB payments are not wages but are treated as wages for federal income tax withholding, SUB payments are also not wages for FICA purposes. The court also rejected the IRS argument that the Rowan case no longer controls.
Bottom line: Quality Stores is entitled to the refund.
Notably, this outcome conflicts with the ruling in a case with similar circumstances decided by the Court of Federal Claims (CSX Corporation v. United States, CA-FC, 101 AFTR2d 2008-1120, 3/6/08). Not surprisingly, the IRS has already requested the court to reconsider its decision. If it loses the appeal, it will almost certainly petition the US Supreme Court to resolve the issue once and for all.
So what should you do for clients who find themselves in this pickle? The safest approach for employers outside of the Sixth Circuit is to continue to withhold and deposit payroll taxes. For these and other clients who have already paid the taxes, file a protective claim preserving the statute of limitations on payroll tax refund claims for any open tax years. The deadline for making such a protective claim is three years from April 15 of the year following the year in which the severance payments were made. Thus, if your client paid FICA tax on severance payments in 2009, you must file the protective claim by April 15, 2013.
More information on filing protective claims is available on the IRS website