The Sixth Circuit Rules In United States V. Quality Stores, Inc. That Severance Payments Paid To Terminated Employees As A Direct Result Of A Work Force Reduction Are Not Subject To FICA Tax

Introduction

Downsizing is a fact of life in the recent U.S. economy. Over the past several decades, employers have involuntarily terminated large numbers of employees and made severance payments totaling hundreds of millions of dollars to the departing workers. The Internal Revenue Service (the "IRS") and courts agree that severance payments are income to the employees and subject to federal income tax. However, the employment tax statutes, FICA for non-railroad employees and RRTA for railroad employees, impose employer and employee taxation on only one subset of "income": "wages" under FICA and "compensation" under RRTA,1 both of which are generally defined as remuneration received for services rendered. Courts have generally held that normal severance payments are "wages," sometimes citing for support the legislative history to the Social Security Amendments of 1949 defining dismissal payments (any payment paid by an employer to an employee on account of an employee's involuntary separation from the service of the employer) as wages for FICA. But what about severance payments paid to employees as a direct result of a work force reduction? In 1990 the IRS ruled that lump sum severance payments paid to employees who were involuntarily separated as a direct result of a work force reduction were wages for FICA and compensation for RRTA because they were indistinguishable from dismissal payments.2 Earlier this month, the Sixth Circuit disagreed, holding that work force reduction severance payments are not dismissal payments, but non-wage supplemental unemployment compensation benefits ("SUB payments") that are not subject to FICA tax. The Sixth Circuit reached its decision after careful examination of a half century of IRS pronouncements, the FICA and federal income tax withholding statutes and legislative history, and relevant Supreme Court precedent. In reaching its decision, the Sixth Circuit declined to follow a contrary 2008 Federal Circuit decision that similar work force reduction severance payments were taxable wages under FICA under controlling IRS guidance.

The Sixth Circuit case is United States v. Quality Stores, Inc., No. 10-1563, 2012 WL 3871364, (6th Cir. Sept. 7, 2012) ("Quality Stores"), in which a three-judge panel unanimously affirmed the lower court's decision that the severance payments at issue were not subject to FICA tax.3 The United States has not yet announced whether it will seek a panel or en banc rehearing, or U.S. Supreme Court review of the Sixth Circuit's decision by filing a petition for a writ of certiorari.4 In order to be timely, a petition for a rehearing must be filed within 45 days after entry of judgment, unless a court order shortens or extends the time. In order to be timely, a petition for a writ of certiorari must be filed within 90 days after entry of the judgment, unless the government files a petition for rehearing by the Sixth Circuit, in which case the 90 day period would run from the date of the denial of the petition for rehearing or, if rehearing is granted, from the date of the subsequent entry of judgment.

Factual and Procedural Background

Quality Stores was the largest agricultural implement retailer in the United States, serving farmers, hobby gardeners, skilled trade persons, and do-it-yourself customers. Prior to and pursuant to a bankruptcy reorganization, Quality Stores closed all its 374 stores, all its distribution centers, and terminated the employment of all its employees. Quality Stores made severance payments to those employees whose employment was involuntarily terminated. The government and Quality Stores agreed that all the severance payments resulted directly from a reduction in force or the discontinuance of a plant or operation.

Severance payments were paid under both a Pre-Petition Severance Plan and a Post-Petition Severance Plan. Payments made under neither plan were tied to the receipt of state unemployment benefits, nor were they attributable to the provision of any particular services. Payments under the Pre-Petition Plan were paid periodically under the normal payroll schedule. Payments under the Post-Petition Plan were paid in a lump sum because the affiliated companies were liquidating and it was not feasible to pay the amounts over time. Neither Plan required employees to be unemployed to receive the payments. The Plans covered both management and hourly employees. Under the Pre-Petition Plan, salaried employees received an average of 11.4 weeks of severance pay and hourly employees an average of 4.2 weeks of severance pay. Under the Post-Petition Plan salaried employees received 5.2 weeks of severance pay, while hourly employees received 3.1 weeks of severance pay.

Because the severance payments constituted gross income to the employees for federal income tax purposes, Quality Stores reported the payments as wages on W-2 forms and withheld federal income tax. Quality Stores also paid the employer portion of the FICA tax (approximately $571,000) and withheld and remitted to the government the employee portion of the FICA tax (approximately $429,000). Because Quality Stores did not agree with the IRS's current ruling position that the severance payments constituted wages for FICA purposes, Quality Stores and affiliates (the "Taxpayer") filed claims for refund5 of both the employer tax and, to the extent that they had obtained written permission from employees to file claims on their behalf, the employee tax as well. In their claims for refund, the Quality Stores companies took the position that the severance payments were not wages but instead constituted SUB payments that were not taxable under FICA. When the IRS neither granted nor denied the refund claims, the Taxpayer filed an adversary action in bankruptcy court in 2005.6

The bankruptcy court agreed with the Taxpayer that the...