Quality Stores Decision Muddies the Waters on the FICA Tax Treatment of Severance Pay

Tax and Employee Benefits Alert

After nearly two years of believing the issue was settled, on February 23, 2010, taxpayers were startled to learn that the U.S. District Court for the Western District of Michigan affirmed the Bankruptcy Court’s decision in In re Quality Stores, Inc., 383 B.R. 67 (Bankr. W.D. Mich. 2008), by holding that severance payments made to employees pursuant to an involuntary reduction in force were not “wages” for FICA tax purposes. See United States v. Quality Stores, Inc., 2010 U.S. Dist. LEXIS 15825 (W.D. Mich. Feb. 23, 2010).

The U.S. District Court followed the lower court decision in CSX Corporation v United States, 52 Fed. Cl. 208 (2002). In that case, the U.S. Court of Federal Claims concluded that involuntary layoff payments are exempt from FICA taxes if these payments qualify as “supplemental unemployment compensation benefits” (“SUB pay”) under section 3402(o)(2) of the Internal Revenue Code. Although this cited statute covers income tax withholding, not FICA taxes, the lower court in CSX concluded that any statutory exemption from “wages” like that provided for these involuntary severance benefits must be deemed to extend to FICA taxes as well, unless the IRS provides a different rule by regulation. This decision sparked thousands of refund claims by employers trying to recoup the employer and employee FICA taxes paid on all forms of involuntary severance. These claims were largely held in abeyance by the IRS while the appeal was pending. In CSX Corporation v. United States, 518 F.3d 1328 (Fed. Cir. 2008), the U.S. Court of Appeals for the Federal Circuit reversed the lower court on this issue and the IRS proceeded to disallow the claims held in abeyance.

The U.S. District Court’s decision in Quality Stores, Inc. will cause many employers to consider once again whether refund claims should be filed as a protective measure. In deciding whether to take this step, distinctions between the circumstances surrounding the two lines of cases in CSX and Quality Stores, respectively, should be considered. First, unlike that of the U.S. Court of Appeals for the Federal Circuit, a decision of the U.S. District Court for the Western District of Michigan does not provide precedential value beyond Michigan. Moreover, in the unlikely event that the U.S. Court of Appeals for the Sixth Circuit were to affirm the District Court’s decision, the IRS would not follow this case beyond the Sixth Circuit – the result being that taxpayers outside the Sixth Circuit will have a greater challenge with persuading the IRS on the merits of their claims. Second, it is our understanding that the IRS will no longer hold these types of refund claims in abeyance pending resolution of a docketed case, and will instead routinely reject the refund claims as they are filed based on the CSX decision by the Federal Circuit, a court of national jurisdiction. Employers who decide to file refund claims will have two years from the date the refund claim is rejected to file a refund action in the appropriate U.S. District Court.

We believe that, on appeal, the U.S. Court of Appeals for the Sixth Circuit is more likely to be persuaded by the well reasoned opinion of the Federal Circuit in CSX and thus will not affirm the lower court’s holding in Quality Stores, Inc. Nevertheless, employers, particularly those residing within the jurisdiction of the Sixth Circuit (i.e., Kentucky, Ohio, Michigan, and Tennessee) who made significant involuntary severance payments to employees, may want to consider filing protective FICA tax refund claims for 2006, which is the oldest calendar year for which the statute of limitations is set to expire on April 15, 2010. A decision to file FICA tax refund claims for later years may be deferred for the time being. Attorneys in Miller & Chevalier’s Employee Benefits group have filed hundreds of these claims over the years, and therefore we have developed an efficient procedure to assist the employer with that endeavor and thereby ensure that expenses are minimal. The deadline for filing FICA tax refund claims for 2006 severance payments is April 15, 2010. Please let us know if you need any assistance.

For additional information, please contact any of the following attorneys:

Thomas Cryan, Jr.

Marianna Dyson, mdyson@milchev.com, 202-626-5867

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