Potential FICA Tax Refunds for Severance Pay
Author: Tim Deisher
The 6th Court of Appeals recently affirmed the lower court’s ruling in United States v. Quality Stores, Inc. that severance payments are exempt from FICA tax if certain criteria are met. This ruling is in contrast to the decision in CSX Corporation Inc. v. United States, where the U.S. Court of Appeals reversed the U.S. Court of Federal Claims and ruled that unless the very narrow exceptions outlined in IRS Revenue Ruling 90-72 applied, severance pay was subject to FICA tax. On October 18, 2012, the IRS filed a petition for an en banc review, i.e., review by the full court, of the Quality Stores decision by the 6th Circuit Court of Appeals.
Quality Stores, Inc. operated a chain of retail stores. Due to economic difficulties, Quality closed several stores and distribution centers and, as a result, made periodic and lump sum severance payments to employees due to their involuntary separation from service. Quality considered the payments wages and withheld income tax and employment taxes and reported the wages on Form W-2. At the time, the IRS exempted involuntary severance payments from FICA taxes as long as the payments met certain tests—namely that they're based on “state unemployment benefits” and given as a series of payments. Quality did not meet IRS requirements, but challenged the IRS position and filed refund claims in excess of $1 million for the FICA tax paid on the severance payments. The 6th Circuit, affirming a district court, agreed with Quality that severance pay meeting the requirements for federal tax withholding is exempt from FICA. To qualify, the severance payment must meet all of these requirements:
- Amount is paid to an employee
- Payment is pursuant to an employer’s plan
- Payment is due to an employee’s temporary or permanent involuntary separation from employment
- The separation results directly from reduction in force, discontinuance of a plant or operation or similar conditions
- The payment is included in the employee’s gross income
While no definition for “reduction in force” is provided in the Internal Revenue Code or Regulations, permanent elimination of a position would appear to qualify.
Employers in the 6th Circuit
This decision directly affects taxpayers located in the 6th Circuit (Kentucky, Ohio, Michigan and Tennessee). For employers in these states that paid involuntary severance payments to employees after 2008, the case provides support to file FICA refund claims for years still open under the statute of limitations, i.e., 2009 - 2012. Employers in the 6th Circuit that anticipate making severance payments meeting the above five criteria should consider whether to withhold and remit FICA tax. The Appeals Court decision provides support to not withhold FICA taxes nor pay the employer share. However, if the IRS ultimately prevails either from reversal of the decision by the full court in the 6th Circuit or on a successful appeal to the Supreme Court, it may be difficult to collect the employee share of FICA by the severed employee. Employers also could be subject to penalties and interest. Due to this risk, the safer alternative would be to pay the FICA tax and file a refund claim.
Employers Outside the 6th Circuit
Employers outside the 6th Circuit that paid involuntarily severance payments to employees after 2008 should consider filing protective refund claims for open years (2009 - 2012). They should continue to withhold FICA tax on current payments and track the 6th Circuit decision to assess filing protective refund claims.
Statute of limitations – The statute of limitations for all four quarters of FICA tax paid timely for 2009 is April 15, 2013. As a result, affected employers may want to monitor the Quality case for a few months. If the petition for en banc review is denied by the 6th Circuit Court of Appeals, the IRS may appeal to the Supreme Court. The appeal must be filed within 90 days of the date of the decision on the rehearing petition. Therefore, employers could wait to see if action is taken prior to year-end and then consider the options discussed above.
Filing of a claim for refund – An employer files a refund claim on Form 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund, for the periods involved and includes a detailed explanation that the claim is filed as a result of the Quality case. If the employer does not want to file a protective claim but an employee does, the employee can file a refund claim on Form 843, Claim for Refund and Request for Abatement. A statement should be obtained from the employer about the employer’s position on filing a claim.
Procedural requirements – Revenue Ruling 81-310 requires an employer to secure the written consent of the former employee(s) authorizing the employer to file the claim on the employee’s behalf for their share of FICA. While employee consent forms are not required prior to filing an employer’s refund claim, they must be obtained before the claim can be perfected. If there is a reasonable effort to obtain consent but the employee fails to furnish the statements, the employer may still claim a refund for its share of FICA overpayment. Refunds received from the IRS must be carefully processed by the employer, separating employer and employee shares of FICA as well as interest on the refund. The employee’s refund portion is entitled to a higher rate of interest than the rate paid on employer refunds.
Given the split between the 6th Circuit and Federal Circuit, as well as the potential money at stake, the IRS will likelyappeal the decision to the Supreme Court if its request for en banc review is denied. Failure to file protective claims for FICA taxes paid on qualifying severance payments in prior years could result in lost refund opportunities if the Quality decision stands.