Mike Melbinger

October 15, 2012

I had skipped this important potential cost-saving issue to focus on SEC and other developments for proxy season. However, I have begun to see notes and articles on it in other sources, so I decided to address it for readers. (See, for example, “Sixth Circuit Affirms Quality Stores Decision on FICA Taxation of Severance Pay – Billions of Dollars in Refund Claims Are at Issue,” Monday, October 1, 2012, http://www.bna.com/sixth-circuit-affirms-n17179869952/). Last month, the Sixth Circuit Court of Appeals, in a carefully reasoned opinion, held that Supplemental Unemployment Benefits (SUB) payments made by Quality Stores were not “wages” for FICA tax purposes (and IRS must repay both the employee and the employer portions of the tax paid on the SUB payments. U.S. v. Quality Stores Inc., 424 B.R. 237 (W.D. Mich. 2010).

The beauty of a SUB Plan is that it allows an employer to pay severance to former employees without those payments being subject to FICA taxation. Thus, the employer and the employee each avoid payment to the IRS 7.65% of the severance payment.

The only fly in the ointment that may cause employers not to adopt a SUB Plan right away is that the Sixth Circuit’s decision creates a circuit court split with the Federal Circuit and its 2008 decision in CSX Corporation v. United States, 518 F.3d 1328 (Fed. Cir. 2008). The CSX case put a damper on employers’ use of SUB Plan to save money for themselves and their former employees, despite the fact that the Internal Revenue Code explicitly provides for such plans. However, we expect that the Quality Stores decision will create renewed employer interest in SUB Plans.

Pursuant to a bankruptcy reorganization, Quality Stores closed all of its stores and distribution centers and terminated the employment of all of its employees. Quality Stores made severance payments to the employees that were terminated involuntarily. Severance was based on job grade and management level in the organization. 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’s share of FICA tax and withheld each employee’s share of FICA tax. However, Quality Stores then argued that the severance payments were not “wages” but instead were “supplemental unemployment compensation benefits” under Internal Revenue Code Sec. 3402(o)(2), and therefore were not taxable under FICA. A federal district judge agreed and now the Sixth Circuit has upheld that decision.

The Sixth Circuit analyzed the SUB Plan established by Quality Stores and found that it satisfied the five-part statutory test to qualify as SUB payments under Code Sec. 3402(o)(2)(A) and Treas. Reg. Sec. 31.3401(a)-1(b)(14)(ii). (SUB Plans must satisfy a number of requirements set forth in the Code, so don’t try this at home.)

Parsing this definition into its five separate elements, Congress has provided that a SUB payment is: (1) an amount paid to an employee; (2) pursuant to an employer's plan; (3) because of an employee's involuntary separation from employment, whether temporary or permanent; (4) resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions; and (5) included in the employee's gross income.

All payments Quality Stores made to its former employees, whether under the Pre- or Post-Petition Plan, satisfy this five-part statutory test to qualify as SUB payments. The parties stipulated below that: (1) Quality Stores made the payments to employees; (2) pursuant to company plans; (3) because of the employees' permanent separation from employment; and (4) resulting directly from a reduction in force or the discontinuance of a plant or operation.

* * *

Because the title and legislative history clarify any ambiguity in the statute, we are convinced that Congress characterized SUB payments as “non-wages” and Congress enacted §3402(o) simply to extend withholding to these “non-wage” payments to benefit taxpayers. In light of this clear congressional intent, we approve the bankruptcy court's reasoning that if SUB payments are not “wages” but are only treated as if they were “wages” for purposes of federal income tax withholding, then SUB payments also are not “wages” under the nearly identical definition of that term found in the FICA statute. The analytical bridge for this step in our reasoning arises from the Supreme Court's decision in Rowan Cos. v. United States, 452 U.S. 247, 255–57 (1981).

* * *

Accordingly, we conclude, under the stipulated facts of this case, that the payments Quality Stores made to its employees pursuant to the Pre- and Post-Petition Plans qualify as SUB payments under I.R.C. §3402(o). Because Congress has provided that SUB payments are not “wages” and are treated only as if they were “wages” for purposes of federal income tax withholding, such payments are not “wages” for purposes of FICA taxation.

The Sixth Circuit acknowledged the Federal Circuit’s 2008 decision in CSX Corp. v. United States, but rejected it. The Court also found that IRS Revenue Rulings conflict with Congressional intent. “We decline to imbue the IRS revenue rulings and private letter rulings with greater significance than the congressional intent expressed in the applicable statutes and legislative histories.”

In CSX Corp., 518 F.3d at 1346, the Federal Circuit adopted the IRS's eight-part administrative definition of SUB pay set out in Rev. Rul. No. 56-249 and Rev. Rul. 90-72 rather than the express statutory definition provided by Congress in §3402(o). That court characterized the payments before it as “dismissal pay” subject to FICA tax. Id.

By contrast, we resolve the tension between the statutory enactments and the IRS revenue rulings in favor of the expressed will of the legislature. Applying the five-part definition that Congress enacted in §3402(o)(2)(A), the payments made by Quality Stores to its former employees qualify as SUB payments, not “dismissal pay.” And as we have explained, SUB payments are not subject to FICA tax.

Many employers already have adopted SUB Plans in reliance on the plain wording of Code Sec. 3402(o)(2).
Those that have, may want to file for a FICA tax refund. Those that have not might want to give the issue some thought.





On October 15, 1910, the University of Illinois held the first ever "Homecoming" football weekend. The Fighting Illini met their great rival, the University of Chicago Maroons, coached by Amos Alonzo Stagg, which Illinois had not beaten in seven years. ( Actually, both the University of Missouri and the University of Illinois lay claim to establishing the tradition of homecoming on college campuses, but since I write the Blog and I went to Illinois Law School . . .)