Be Cautious of Ruling that Severance Pay Isn't Subject to FICA

It seems almost certain that the IRS will appeal this decision

By William Hays Weissman, Littler Mendelson PC April 5, 2010

Update: See IRS May Owe Employers Millions in FICA Refunds, SHRM Online Legal Issues, October 2012


In February 2010, a federal district court in Michigan held in United States v. Quality Stores, Inc. that severance payments were not wages subject to Social Security and Medicare taxes (FICA taxes). This decision appears to conflict with a decision of the Court of Appeals for the federal circuit. It also is likely to be challenged by the Internal Revenue Service (IRS). Businesses have reason to be cautiously optimistic but should be hesitant to stop reporting FICA on severance payments until a more conclusive outcome is reached. Nonetheless, employers that have paid severance in recent years should consider filing protective refund claims with the IRS in order to preserve their rights.


Quality Stores, Inc. operated a chain of retail stores. Falling on hard times, it filed for bankruptcy. The company closed many of its retail stores and laid off numerous employees. It eventually closed the remainder of its stores and laid off its remaining employees.

Quality Stores reported the severance payments as wages on the employees' W-2 forms and withheld federal income tax and the employees' share of FICA taxes. It also paid its share of FICA taxes.

In 2002, Quality Stores filed refund claims with the IRS for overpaid FICA, plus interest, on the severance payments. The claims included the employer's share of FICA, and the employees' share of FICA, for those employees who consented to permit Quality Stores to make the refund request for them.

The Bankruptcy Court, relying in part on the Court of Federal Claims 2002 decision in CSX Corp. v. United States, ruled in favor of Quality Stores, finding that the severance payments were not "wages" for purposes of FICA taxes. In 2008, following the decision of the Court of Appeals for the Federal Circuit, which reversed the Court of Federal Claims in CSX, the IRS moved for reconsideration. Upon review, the Bankruptcy Court again affirmed its decision that the severance payments were not wages subject to FICA taxes. The IRS appealed to the federal district court, which affirmed the Bankruptcy Court.

Considerations for Employers

Given that there are now two court decisions reaching opposite conclusions, the potential cost to the Treasury of this issue, and the IRS's position as set forth in Revenue Ruling 90-72, it seems almost certain that the IRS will appeal this decision. Further, it is likely that other courts will weigh in on this issue as other refund claims get tried, making it possible that the issue will have to be decided by the U.S. Supreme Court.

Of course, the IRS could easily resolve the problem prospectively by promulgating regulations, which both the CSXs and Quality Stores courts pointed out had never been issued, to clearly and unequivocally decouple the treatment of "supplemental unemployment benefits" (SUB) pay for FICA and income tax withholding purposes.

In light of the current uncertainty, and expecting that the IRS will issue assessments to employers that decline to withhold and remit FICA taxes on severance payments, employers should continue to withhold FICA on severance payments that fall within the definition of IRC section 3402(o)(2); that is, on severance paid from a plan to workers who were terminated involuntarily because of a reduction in force or plant closure.

The exception to this recommendation would be if the severance qualifies as SUB payments under Revenue Ruling 90-72. However, given the various requirements of Revenue Ruling 90-72, this is unlikely to be accomplished easily without significant planning.

After filing returns and remitting FICA taxes on severance, employers can, however, file claims for refund of their share of FICA and any employee-paid FICA taxes that an employee consents to have refunded. In addition, employers may file refund claims for any such severance payments made for any open statute-of-limitations period. For example, refund claims for the 2006 tax year must be filed by April 15, 2010. Nonetheless, any protective refund claims that are filed will likely be held by the IRS pending resolution of this issue, which might take years.

William Hays Weissman is a shareholder in Littler Mendelson's Walnut Creek, Calif., office, in the Employment Taxes Practice Group. He advises and represents employers in a broad range of employment tax matters, including employment tax audits, protests and appeals before state taxing agencies and the IRS as well as litigation in civil court, drafting employment and independent contractor agreements, and counseling on the tax implications of various employer provided benefits.

The above article is an excerpt from an analysis in ASAP, published by Littler Mendelson, the national employment and labor law firm. Reposted with permission. A longer version of the article appears on the firm's website, here.

Editor’s Note: This article should not be construed as legal advice.

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