Kathryn A. English, Esq. and Holly S. McCann, Esq.
A decision issued in April 2002 by the U.S. Court of Federal Claims may enable employers to obtain a refund of social security or "FICA" taxes paid on certain kinds of severance payments. In CSX Corporation, Inc. v. United States, the court rejected the Internal Revenue Service's interpretation of what constitutes supplemental unemployment compensation benefits that are exempt from FICA. The court adopted a broader standard, which could exempt many payments previously thought to be subject to FICA taxes.
Under Section 3402(o)(2) of the Internal Revenue Code, supplemental unemployment compensation benefits are payments that an employer makes to an employee on account of the employee's involuntary separation of employment resulting directly from a reduction in force, the discontinuance of a plant or operation or other similar conditions. The court held that supplemental unemployment compensation benefits as defined by that section are not wages for purposes of FICA.
As part of a reduction in force, CSX Corporation paid employees placed on layoff status a fixed percentage of average monthly compensation, with the duration of the payment governed by an employee's length of service. Laid-off employees remained on the company's payroll and could be offered another position based on seniority, but if an employee declined another position, he or she became ineligible for the continued receipt of benefits. The court held that these payments were supplemental unemployment compensation benefits and were exempt from FICA.
CSX made two other kinds of payments that the court ruled were not supplemental unemployment compensation benefits and were therefore still subject to FICA taxation:
- Employees placed on standby status were guaranteed a certain minimum compensation per pay period adjusted by amounts paid for work actually performed. Standby employees remained on the company's active payroll and were subject to recall on an as-needed basis.
- Employees who voluntarily agreed to terminate their employment relationship with the company were paid separation payments.
According to the court, the first of these kinds of payments were not made on account of a separation from employment, because the employees were still on the company's active payroll and received a guaranteed minimum compensation. The last category of payments were not made on account of an involuntary separation, because the employees' resignation was a voluntary action taken in response to the company's offer of severance payments.
Guidance from the Internal Revenue Service prior to this decision suggested that supplemental unemployment compensation benefits are exempt from FICA only if they are linked to the receipt of state unemployment compensation and not paid in a lump sum. Accordingly, most severance pay had been considered subject to FICA taxation, even if made on account of an employee's involuntary separation of employment under one of the scenarios described above.
At this point, employers should not stop paying FICA taxes on severance pay in reliance on the CSX decision. It is unclear whether the court's decision will hold up on appeal or whether the decision will have any effect on the position taken by the Internal Revenue Service in audits. Until this issue is further clarified, employers that stop paying FICA taxes on severance pay risk being assessed penalties by the Internal Revenue Service.
Employers, however, may wish to file protective refund claims for FICA taxes paid on account of severance pay, so that they preserve their ability to seek a refund before the statute of limitations closes. A refund claim is filed with the Internal Revenue Service on Form 843, generally no later than three years from April 15 of the year following the tax year to which the FICA taxes relate. For example, the statute of limitations for FICA taxes paid on time for the 1999 tax year expires on April 15, 2003.
Kathryn A. English and Holly S. McCann are attorneys in the Tax, Estates and Benefits Department at Eckert Seamans Cherin & Mellott, LLC (telephone 412-566-6000).