In Quality Stores, Inc. v. United States,1 the United States District Court for the Western District of Michigan held that severance payments made by employers to employees pursuant to an involuntary separation are not subject to FICA taxation. This case, which Pepper handled before the district court, may have far-reaching effects on employers’ and employees’ need to pay Social Security and Medicare (FICA) taxes. Even if the decision does not overturn current law with regard to FICA taxes, it could lead to further litigation on the issues addressed by the court. Accordingly, taxpayers would be well advised to preserve their refund claims, in some cases immediately, in light of the pending court proceedings.
The Quality Stores Background
Quality Stores operated a chain of retail stores, selling agricultural supplies and related goods. In 2001, Quality Stores went into bankruptcy and eventually closed all of its stores and terminated all of its employees. In the period before its bankruptcy petition, Quality Stores closed more than 60 stores, and terminated approximately 75 corporate employees. Under the severance plan in place, these employees received severance payments that were paid out in accordance with the normal payroll period. After the bankruptcy petition was filed, the remaining stores and distribution centers were closed and all remaining employees of Quality Stores were terminated. These employees also received severance payments; however, these employees received lump-sum payments under a different severance plan. For both the pre-petition and post-petition severance pay plans, payment of the severance was not linked to the receipt of state unemployment benefits. Quality Stores reported these payments as wages on the former employees’ W-2s and withheld both federal income tax and FICA from them, and paid the employer’s FICA share. However, Quality Stores eventually filed refund claims for both its FICA payments and also on behalf of consenting employees for their shares of the FICA payments. After the bankruptcy court upheld Quality Stores’ refund claims, the IRS appealed. Pepper Hamilton lawyers Robert Hertzberg, Mike Reed and Lisa Petkun represented Quality Stores in the district court and wrote the district court brief.
The Quality Stores Decision
The crux of the Quality Stores decision is whether payments made to terminated employees fall within the definition of “wages,” and thus are subject to FICA, or into the exception for supplemental unemployment compensation benefits (SUB) payments and thus are exempt. Per the Internal Revenue Code, SUB payments are amounts paid to an employee because of an employee’s involuntary separation resulting directly from a reduction in force, discontinuance of a plant or operation, or other similar conditions.2
Under Revenue Ruling 90-72,3 the IRS takes the position that in order for SUB payments to be exempt from the definition of “wages,” and thus exempt from federal income tax withholding and FICA, they must be paid under a plan in which severance pay is linked to the receipt of state unemployment compensation and is not paid in a lump sum. In 2008, the Court of Appeals for the Federal Circuit upheld this definition in CSX Corp. v. United States,4 and in doing so reversed a lower court decision that was decided in favor of the plaintiff on similar grounds as Quality Stores.
However, on February 23, 2010, the United States District Court for the Western District of Michigan affirmed the holding of the bankruptcy court that Quality Stores’ payments made to its laid-off employees fall within the exception to the definition of “wages” for SUB payments. The court rejected the IRS’s argument that the payments were wages subject to FICA. The court reasoned that the plain language of Section 3402(o)5 and the legislative history make it clear that a SUB payment is not a payment of wages, which is why Congress had to treat it “as if it were a payment of wages” for withholding tax purposes. It further noted that SUB payments are intended as a substitute for FICA protection for employees, and thus taxing SUB payments would run counter to the congressional intention to collect FICA so that individuals could receive remedial monetary support under the Social Security Act. Accordingly, the court held that Quality Stores was entitled to refunds for the FICA payments it had made attributable to the SUB payments.
Present Impact of the Decision
The Quality Stores decision, if followed by other courts, could create significant opportunities for taxpayers and generate billions of dollars in refunds for companies that have been in the unfortunate position of having to close operations or reduce their workforce. However, it is important to keep the immediate impact of the case in perspective.
First, Quality Stores is a federal district court decision, in contrast to the CSX case, which was decided by the Court of Appeals for the Federal Circuit. At present, the Quality Stores decision is at best persuasive authority. By contrast, the CSX case has broad precedential authority over all decisions in the Federal Circuit, and thus true national reach. In addition, the IRS may appeal Quality Stores to the Sixth Circuit Court of Appeals. Moreover, even if the decision were to be affirmed by the Sixth Circuit, it would then be precedential only in Kentucky, Ohio, Michigan, and Tennessee – the geographical boundaries of the Sixth Circuit.
Second, a number of factors must come together in order for Quality Stores to become precedential in other federal circuits. Taxpayers whose refund claims were rejected would need to file lawsuits, and only when a case reached a circuit court and a circuit court made a favorable decision would the case become precedent in that circuit. It is difficult to predict how this process will unfold in the coming months. However, it is likely that many refund suits will be filed all over the country, given that present economic circumstances have forced many companies to conduct broad reductions in force. Under current tax law, all such companies should have paid FICA taxes on SUB payments, and the IRS continues to be unwilling to grant any refund claims. That means that numerous companies could be the standard-bearers to import the Quality Stores decision to other circuits.
Finally, the particular facts of Quality Stores could limit its applicability to certain types of severance payments. The case only addressed severance that is paid under a plan or system designed to compensate employees because of a reduction in force, office or plant closing, or another similar situation. It did not involve payments made under a voluntary separation, such as an early retirement plan. Accordingly, if other taxpayers take the IRS to court in other jurisdictions, it is quite likely that issues regarding severance payments made to employees under other circumstances and not covered by the Quality Stores decision will be litigated.
The learning from the Quality Stores decision is that even if a groundswell of companies flood the courts and cause a wholesale reversal in the treatment of severance payments for FICA purposes, this process will take years to reach a national resolution. However, taxpayers only have a three-year statute of limitations in which to seek a refund. The IRS allows taxpayers to file a protective claim that preserves the refund window while a court case regarding the same issue is pending. Protective refund claims are easy to file, generally requiring only a handful of forms and a general statement of the law upon which the taxpayer is relying. Therefore, taxpayers who made severance payments (and thus FICA payments) between 2006 and 2009 should consider filing protective refund claims to preserve their ability to seek FICA refund payments. Taxpayers that made significant payments in 2006 need to file by April 15, 2010 before the 2006 statute of limitations closes.
1 No. 1:09-cv-44 (W.D. Michigan, Feb. 23, 2010).
2 I.R.C. § 3402(o).
3 1990-2 C.B. 211.
4 518 F. 3d 1328 (Fed. Cir. 2008).
5 Unless otherwise stated, all references to “Section” are to the Internal Revenue Code of 1986 (the Code), and all references to “Treas. Reg. Section.” are to the Treasury Regulations promulgated thereunder (the Regulations).
Robert S. Hertzberg, Lisa B. Petkun, Michael H. Reed, Todd B. Reinstein and Marc D. Nickel