Court case could create an upside to severance payments

Severance pay has become an unfortunate fact of life for many companies and employees. But based on a recent court case, there may be some good news for both.

In February, the U.S. District Court for the Western District of Michigan reached a conclusion that could result in sizable refunds for employers who paid severance and the employees who received those payments.
 
The case – United States v. Quality Stores, Inc. – arose when an employer terminated its staff, paid severance and the related payroll tax, and later filed refund claims based on the theory that severance payments made pursuant to a reduction in workforce are not be subject to employment tax. The district court agreed. When the Internal Revenue Service appealed the case, it went to the Supreme Court, which upheld the lower court’s ruling.
 
Here’s what happened.
 
Quality Stores was a retail supplier of agricultural products. In 2001, an involuntary Chapter 11 bankruptcy petition was filed against the retailer and Quality closed all of its stores and distribution centers. Quality’s employees were subsequently terminated and given severance payments based on their length of employment.
 
Quality paid its share of employment taxes and properly issued W-2s for the severance pay and the taxes withheld. Later, in 2002, Quality filed refund claims for the employment taxes paid by the store on the severance payments, and on behalf of consenting employees for employment tax withheld. The refund claims totaled $1,000,125 for overpaid employment taxes, plus interest.
 
When the case went to Michigan’s U.S. District Court, the court ruled that the severance payments represented wage replacement social benefits and were intended as support for terminated workers, rather than as compensation for services rendered. Based on that finding, the court deemed the payments taxable for income tax purposes but not for employment tax purposes.
 
The decision was supported by the Supreme Court case Rowan Companies, Inc. v. United States (452 US 247, 1981). In Rowan, the Supreme Court noted that Congress separated the treatment of income tax and employment tax in certain situations. Applying the same rule in the Quality Stores case, the District Court ruled that the severance payments made by Quality Stores were taxable for income tax purposes, but not for FICA tax purposes.
 
In spite of the Supreme Court’s upholding of the lower court decision, the IRS disagreed and is expected to appeal. The tax agency argues that the payments were made because of employment and therefore are subject to payroll tax.
 
Even so, based on the Quality Stores decision, employers who paid severance and employees who received those payments might be entitled to refunds for tax years that are still open (without regard to extensions). For tax year 2006, that window will close April 15, 2010. Filing a protective claim secures the right to a refund, though interested parties should know refunds likely will not be paid unless the appeals process affirms the Supreme Court decision. The attorneys who represented Quality Stores, Pepper Hamilton LLP, expect the appeals process could take years to run its course.
 
 It’s also noteworthy to mention that in a 2002 case – CSX Corporation v. United States (52 Fed. Cl. 208, 2002) – severance payments also were deemed to be exempt from FICA taxes. The U.S. Court of Federal Claims ruled that the payments qualified as “supplemental unemployment compensation benefits,” or SUB payments (under section 3402(o)(2) of the Internal Revenue Code). That case gave rise to thousands of refund claims that were held in abeyance while the decision was appealed. In 2008, the U.S. Court of Appeals reversed the lower court ruling and the IRS disallowed the refund claims.
 
Some legal experts believe that, if the Quality Stores case sparks large numbers of claims for refund as expected, the IRS will no longer hold those claims in abeyance during the appeals process, but will reject them outright. If that happens, employers will then have two years from the date of the rejection to file a refund action in the appropriate district court.
 
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