IRS May Owe Employers Millions in FICA Refunds
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IRS May Owe Employers Millions in FICA Refunds

By Allen Smith  10/16/2012
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Soon, many employers in Kentucky, Michigan, Ohio and Tennessee may be eligible for refunds from the Internal Revenue Service (IRS) for taxes paid erroneously under the Federal Insurance Contributions Act (FICA), said Steven Friedman, director of the Practice, Procedure and Administration Group at KPMG’s Washington National Tax division, in a webcast on Oct. 15, 2012.

Refunds to employers and employees may be available to employers with a principal place of business in the federal 6th Circuit. In September 2012, the U.S. Circuit Court of Appeals ruled that certain severance payments to former employees are not taxable under FICA (United States v. Quality Stores, No. 10-1563). Receiving the refunds depends on whether the federal government decides to fight the 6th Circuit decision.

Quality Stores

The FICA tax on employee wages funds the Social Security and Medicare programs. The employer deducts the tax from the employee’s wages and pays a matching tax, as well.

Quality Stores, a bankrupt agricultural specialty retailer, sought a refund of $1 million in taxes paid under FICA—$571,127 for the employer share and $428,998 for the employee share. A bankruptcy court granted the refund, holding that severance payments the company made to employees upon a reduction in force and closure of the business constituted supplemental unemployment compensation benefits that are not taxable as wages under FICA.

The 6th Circuit affirmed. Supplemental unemployment compensation benefits (SUB payments) are not wages under FICA, the appeals court decided. The court noted that such payments are treated as if they were wages for purposes of federal income tax withholding, so they are not wages under the nearly identical definition of that term in the FICA statute.

“If SUB payments constituted ‘wages,’ then unemployed workers could not qualify for unemployment benefits under most states’ laws, and the unavailability of unemployment benefits would largely defeat the purpose of SUB payments,” the court stated.

The 6th Circuit rejected Internal Revenue Service (IRS) Revenue Ruling 90-72, which held that to be exempt from wages under FICA, SUB payments must be made to involuntarily separated employees under a plan that is designed to supplement the receipt of state unemployment compensation. The IRS stated that payments in a lump sum are not considered linked to state unemployment compensation and are not excludable.

“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,” the 6th Circuit stated. “Congress, not the IRS, prescribes the tax laws; IRS revenue rulings have only such force as Congress chooses to give them, and Congress has not given them the force of law.”

The 6th Circuit noted, however, that another appeals court, the Federal Circuit, reached the opposite conclusion and applied Revenue Ruling 90-72 to determine that severance payments are taxable wages under FICA.

The 6th Circuit agreed with the Federal Circuit that, “this issue of statutory construction is complex and that the correct resolution of the issue is far from obvious.” The 6th Circuit added, “While the Supreme Court may ultimately provide us with the correct resolution of these difficult issues under the law as it currently stands, only Congress can clarify the statutes concerning the imposition of FICA tax on SUB payments.”

Refund Opportunities

The conflict in the circuit courts is “causing a lot of uncertainty and confusion,” noted Karen Field, principal with the Compensation and Benefits Support Group for KMPG’s Washington National Tax division.

“While these conflicting decisions leave employers with a less than certain national response, the Quality Stores ruling could open an opportunity for employers with their ‘principal place of business’ in the 6th Circuit for potential refund and/or prospective savings opportunities,” said Scott Schapiro, principal, International Executive Services, with KPMG.

Employers with a principal place of business in the 6th Circuit, which encompasses Kentucky, Michigan, Ohio and Tennessee, may choose to seek a full refund on behalf of themselves and employees who grant employers permission to seek FICA tax refunds for them. Employees outside the 6th Circuit may file protective claims with FORM 941-X, Schapiro added.

Employers would have to determine refunds on an employee-by-employee basis, not as a gross payment, Schapiro noted. If an employer decides to proceed with this, it will have to contact employees who received the severance payment to ask permission to seek the refund on their behalf. The employees have 45 days in which to answer. If there is no response, the employer may seek a refund only for itself.

In the 6th Circuit decision, Quality Stores asked 3,100 former employees to let the company file FICA tax refund claims on their behalf, and 1,850 consented.

If the IRS decides to refund employers in the 6th Circuit or is ordered to refund employers that sue the IRS for refunds in that circuit, it will issue one refund check for the employer and one for all employees, Schapiro said. He noted that employers will then have to issue separate checks to affected employees, which could number in the thousands. Schapiro urges employers to weigh the consequences of this issue carefully.

In addition, employers with principal places of business in the 6th Circuit should look at the prospective treatment of severance payments in the case of staff reductions in force or business closures, as there is the opportunity to treat these payments as not taxable for FICA purposes, he added.

The Justice Department has until Oct. 22, 2012, to request a rehearing in the 6th Circuit, and until Dec. 6, 2012, to file a certiorari petition with the U.S. Supreme Court.

Allen Smith, J.D., is manager, workplace law content, for SHRM.
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