At long last, the U.S. Supreme Court has agreed to resolve a matter that has perplexed payroll managers for the last few years. In the controversial Quality Stores case, the Sixth Circuit Court of Appeals ruled in 2012 that severance payments should not be treated as wages for payroll tax purposes, a conflicting decision with other federal courts. However, the IRS refused to throw in the towel.
Now, the nation’s top court has granted certiorari to review this matter. It is expected to provide a clear path to follow in the future (U.S. v. Quality Stores, CA- 6 09/07/2012, 110 AFTR2d 2012-5827, cert. granted 10/01/13).
Federal payroll taxes are a requirement for both employees and employers. For 2013, an employee must pay FICA tax of 6.2 percent for Social Security and 1.45 percent for Medicare on wages up to the “Social Security wage base” of $113,700. (For 2014, the amount is $117,000.) Once an employee reaches the wage base, he or she must only pay 1.45 percent because there is no limit for Medicare tax. The employer must also pay its corresponding share of these payroll taxes. The wage base is indexed annually.
As a general rule, wages that are subject to income tax withholding are also treated as wages for payroll tax purposes. However, certain types of payments made to employees are excluded from the definition of “wages” for federal income tax purposes, including Supplemental Unemployment Compensation Benefits (SUB). To qualify as SUB, payment must be:
- Made to an employee
- Pursuant to an employer’s plan
- Due to an employee’s involuntary separation from employment, whether temporary or permanent
- Resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions
- Included in the employee’s gross income.
Because severance payments are clearly wages for federal income tax purposes, the IRS has long maintained that any severance payments handed out to terminated workers are subject to payroll taxes. Traditionally, the courts have gone along with the IRS’ point of view, or at least until the Quality Stores case came along.
Depending on the eventual outcome in the Quality Stores case, some employers may be in line for a payroll tax refund. In the meantime, it’s wise to consider protecting your interests.
An employer may be able to file a protective claim to preserve the statute of limitations on payroll tax refund claims for open years and later file a supplementary claim with the requisite employee consents and exact calculations. The due date for making a protective claim is three years from April 15 of the year following the year in which the severance payments were made.
Until the matter is resolved by the Supreme Court, employers are generally advised to continue withholding FICA taxes on severance payments made in connection with involuntary termination of employees. Obtain additional guidance from your tax or payroll adviser for your particular situation.
Key Facts of the Case
Quality Stores, a large retail chain, was forced to close more than 60 stores and nine distribution centers after it encountered financial difficulties. It also fired approximately 75 employees at its corporate offices. An involuntary Chapter 11 bankruptcy petition was filed against the retail outfit in 2001. Quality Stores then closed more than 300 stores and all of its distribution centers. Finally, it discharged all the employees still remaining on the payroll.
The terminated employees received severance in amounts based in part on their date of termination. Initially, Quality Stores reported the severance payments as wages on employees’ W-2s, withheld the appropriate amount of income taxes and payroll taxes, and paid its fair share of the payroll taxes. However, in 2002, it filed refund claims for overpaid payroll taxes totaling $1,000,125, plus interest, on the severance payments.
The district court in Michigan ruled the severance payments should not be characterized as wages for payroll tax purposes. It said that the payments were in the nature of SUB payments. In its decision, the district court also referenced a landmark case (Rowan Companies, Inc., 452 US 247, 1981), in which the U.S. Supreme Court determined that Congress intended a uniform definition of “wages” for income tax and payroll tax purposes. Subsequently, Congress passed a “decoupling rule” separating the imposition of payroll taxes from the treatment of income taxes in existing regulations.
In 2012, the Sixth Circuit Court of Appeals sided with the district court. It found that Congress has expressly provided that any payment meeting the statutory definition of a SUB payment is treated as if it were a payment of wages. According to the Sixth Circuit Court, Congress didn’t consider SUB payments to be wages, but allowed their treatment as wages in order to facilitate federal income tax withholding. Because SUB payments are not wages, but are treated as if they were wages for federal income tax withholding, SUB payments should also not be wages for payroll tax purposes.
The court also rejected the IRS’ argument that the Rowan case is no longer controlling. When Congress enacted the decoupling rule, it did not provide that wages must be treated differently for purposes of federal income tax withholding and payroll taxes. Instead, the amendment was intended to allow the IRS to issue regulations to provide for different exclusions from wages under FICA than under the income tax withholding laws. The IRS has not issued any regulations under the decoupling amendment.
As a result, the Sixth Circuit Court said the payments were SUB payments that aren’t subject to payroll taxes. However, this ruling directly conflicted with another recent decision. In 2002, the Court of Federal Claims held that severance pay was not subject to FICA, but the Court of Appeals for the Federal Circuit reversed. It ruled that the severance pay involved in the taxpayer’s various downsizing programs was subject to FICA (CSX Corp. v. U.S., CA-Fed. Cir. 3/6/2008).
What’s at stake? If the Supreme Court agrees with the Sixth Circuit Court, the impact for employers and employees alike could be substantial. Even if your company is relatively small, it could save thousands of payroll tax dollars.
Some companies have filed protected claims to preserve the statute of limitations while they continue to withhold payroll taxes on severance payments. This could provide refund opportunities in the future (see right-hand box above). Consult with your tax or payroll adviser for more information in your situation.