Two recent appellate court decisions came to opposite conclusions on the question of whether severance payments are subject to FICA. In CSX Corp.,2 the Federal Circuit, agreeing with earlier decisions of the Third and Eighth Circuits, held that severance payments were subject to FICA; however, in 2012 in Quality Stores, Inc.,3 the Sixth Circuit held to the contrary. To resolve the split in opinions, the Supreme Court agreed to hear Quality Stores. The Supreme Court reversed the Sixth Circuit and held that severance payments to employees who were involuntarily terminated were taxable wages for FICA purposes.4
The origin of the dispute over severance payments is in the income tax withholding statutes. Sec. 3401 defines wages expansively for purposes of income tax withholding.
Section 3401. Definitions. (a) Wages. For purposes of this chapter, the term "wages" means all remuneration (other than fees paid to a public official) for services performed by an employee for his employer, including the cash value of all remuneration (including benefits) paid in any medium other than cash; . . .
Sec. 3402 specifically extends the income tax withholding requirements to several items, including severance payments that qualify as supplemental unemployment benefits (SUBs), which "shall be treated as if it were a payment of wages by an employer to an employee for a payroll period."6
Although supplemental unemployment compensation benefits would qualify as wages under Sec. 3401, the legislative history surrounding the enactment of Sec. 3402(o) indicates that Congress did not consider them to be wages, thus necessitating the enactment of Sec. 3402(o) to make them subject to withholding.
Sec. 3121(a) contains a definition of wages for FICA that is similar to that in Sec. 3401. A number of items are specifically excluded from the FICA definition of "wages" under Sec. 3121, including annuity payments and sick pay, but the FICA statutes do not contain anything similar to Sec. 3402(o).
Rev. Rul. 90-72 also indicates that the definition of SUBs under Sec. 3402 does not apply for FICA but only for income tax withholding. However, in this ruling, the IRS excluded from the definition of wages for FICA SUBs that are linked to the receipt of state unemployment compensation and are not received in a lump sum. In addition, between 1965 and 1974, the IRS issued a series of revenue rulings in which it stated that severance payments are wages for FICA purposes.7
During the 1980s, CSX, a railroad conglomerate, experienced financial difficulties and was forced to reduce the number of its employees significantly. The company adopted a variety of severance programs for its union and nonunion employees that included cash incentives to encourage employees to leave the company and to soften the financial blow of losing their jobs.
The issue before the Federal Circuit in the CSX case was whether payments CSX made to employees under the various severance plans were subject to withholding and taxation under FICA and the Railroad Retirement Tax Act (RRTA). CSX's position was that payments to employees who were separated from employment or whose hours were reduced were not taxable under FICA or the RRTA because the payments were not "wages" for FICA purposes or "compensation" for RRTA purposes.8 The government contended that all of the payments under the various plans were taxable as "wages" or "compensation" within the meaning of FICA and the RRTA, respectively. The lower court had held that some of the payments at issue were taxable and others were not.9
The Federal Circuit agreed with the government and concluded that all of the payments were subject to FICA.10 The court found the taxation of "wages" for FICA purposes turned on the definition and tax treatment of SUBs and whether the definitions and rules applicable to SUB payments for federal income tax withholding purposes apply equally for FICA purposes. CSX argued that, because Sec. 3402(o) states that SUB payments "shall be treated as if they were wages" (emphasis added), they must not be wages for federal income tax withholding purposes. If they are not wages for income tax withholding purposes, they cannot be wages for FICA purposes.
Sec. 3402 defines the term "supplemental unemployment compensation benefits" as "amounts which are paid to an employee, pursuant to a plan to which the employer is a party, because of an employee's involuntary separation from employment (whether or not such separation is temporary), resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar condition, but only to the extent such benefits are includible in the employee's gross income."11 This statute goes on to provide that a SUB payment "shall be treated as if it were a payment of wages by an employer to an employee" (emphasis added) and as a result is subject to federal income tax withholding.12
The primary question presented in this case was whether the statement in Sec. 3402(o) that a SUB payment is to be "treated as if it were a payment of wages" for income tax purposes means, by implication, that SUB payments are not "wages" for either income tax or FICA purposes. The lower court reasoned that, based on the language in the statute and the legislative history, such an inference should be made and that payments meeting the definition of a SUB in Sec. 3402(o) are not actually "wages." Applying the general rule that the Supreme Court expressed in Rowan, thatthe definition of "wages" should be interpreted for FICA in the same way as for income tax withholding, the trial court concluded that FICA taxes should not be imposed on payments meeting the definition of a SUB because those payments are not "wages."13
After an exhaustive analysis of the history and evolution of the statutes, regulations, and revenue rulings regarding the definition of "wages" for purposes of FICA and income tax withholding, the Federal Circuit disagreed. The court noted that the definition of "wages" for FICA purposes has been interpreted to encompass a broad range of employer payments as long as the payments are remuneration for the overall employment relationship. It concluded that the lower court's inference went too far.
If Sec. 3402(o) is read to mean that all payments meeting the definition of a SUB are nonwages, and if this characterization of the payments is deemed to apply in the FICA context, it would create a direct conflict with long-standing court and IRS precedents on the treatment of severance payments as wages. Thus, Sec. 3402(o) should not be interpreted to mean that all payments falling within the statutory definition of a SUB must be deemed to be nonwages for FICA purposes. The scope of Sec. 3402 should be restricted to what Congress intended, which, according to the court, was that the subsection apply only to income tax withholding. It should not, by inference, be extended to apply to FICA. Therefore, the Federal Circuit concluded that payments to the CSX employees under the company's various severance plans were all "wages" for FICA purposes.
Quality Stores, Inc., in the Sixth Circuit
In Quality Stores, Inc., the Court of Appeals for the Sixth Circuit reached a different conclusion.14
Quality Stores was a large agricultural retailer that underwent a Chapter 11 bankruptcy beginning in 2001. During its decline, it terminated employees in stages under two separate severance plans. Quality Stores withheld and paid both the employer and employee portion of FICA tax on the severance payments paid under the plans, but then it filed a refund claim with the IRS on its behalf and on behalf of those former employees who agreed to allow it to pursue their claims.
In the refund claim, Quality Stores took the position that the payments were not subject to FICA. Like CSX, Quality Stores asserted that the payments to employees under the plans were not "wages" but were instead SUB payments that were not subject to FICA. After the IRS neither denied nor granted the refund claim, Quality Stores filed an adversary action in bankruptcy court. The bankruptcy court ordered a full refund after finding that the severance payments to employees constituted SUB payments that are not taxable as "wages" under FICA.15 The federal district court affirmed that decision,16 which was then appealed to the Sixth Circuit.
The Sixth Circuit agreed with the bankruptcy court that the payments qualified as SUB payments as defined in Sec. 3402(o). The court noted that Congress defined "wages" in Sec. 3121(a) for FICA purposes as "all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash."17 It further noted that the term "employment" as used in the statute has been broadly defined by the Supreme Court to include "any service . . . performed . . . for his employer," encompassing "not only work actually done but the entire employer-employee relationship for which compensation is paid to the employee by the employer."18 However, the Sixth Circuit found that SUB payments fall outside the broad statutory definition of "service" because, by definition, an employee is not eligible for SUB pay until the employment relationship has ended, and the payments represent compensation for the lost job.19
The Sixth Circuit recognized that the issue of whether SUB payments constitute "wages" under FICA is a complex question because neither the FICA statute nor the regulations promulgated under the statute specifically address SUB payments. For federal income tax withholding purposes, Congress adopted a definition of "wages" that is almost identical to the FICA definition. Congress specifically defined SUB payments for purposes of federal income tax withholding in a subsection of a statute titled, "Extension of Withholding to Certain Payments Other Than Wages."20 The statute provides that any payment to an employee that meets the definition of a SUB payment "shall be treated as if it were a payment of wages."21 The court concluded that the necessary implication of that wording is that Congress did not consider SUB payments to be wages. The title of the statute and the legislative history clarified any ambiguity in the statute. The court found that Congress intended to characterize SUB payments as "non-wages" and that it enacted Sec. 3402(o) simply to facilitate federal income tax withholding for these "non-wage" payments.
Having found that SUB payments were not wages for income tax withholding, the court determined that, applying the precedent in Rowan, the payments should not be wages for purposes of FICA. The court disregarded the IRS revenue rulings and private letter rulings that treated severance payments as FICA wages, stating that Congress, not the IRS, prescribes tax law and that congressional intent trumps the IRS's opinion.
The Sixth Circuit was mindful that its decision in Quality Stores was at odds with the Federal Circuit's decision in CSX. It acknowledged the CSX court's observation that the matter of statutory construction is complex and is often far from obvious. The court clearly recognized that the Supreme Court would ultimately have to resolve the conflict between it and the Federal Circuit. In conclusion, it noted, however, that ultimately "only Congress can clarify the statutes concerning the imposition of FICA tax on SUB payments."22
Quality Stores, Inc., in the Supreme Court
As discussed above, the Sixth Circuit concluded that the severance payments made by Quality Stores did not fit the definition of "wages" for federal income tax withholding purposes. Thus, by extension, the severance payments also did not constitute "wages" as defined under FICA. The Supreme Court disagreed, finding that FICA's broad definition of "wages" includes severance payments such as these, and Sec. 3402(o) does not change that definition.23
The initial question addressed is whether FICA's definition of "wages" encompasses severance payments. FICA defines "wages" under Sec. 3121(a) as "all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash." Under Sec. 3121(b), the term "employment" includes "any service, of whatever nature, performed . . . by an employee for the person employing him." Applying these definitions, the Court determined that severance payments made to terminated employees are "remuneration for employment" and that common sense dictates that employees received the payments "for employment." The Court noted that, in other cases, it has interpreted the term "wages" broadly to include "the entire employer-employee relationship for which compensation is paid to the employee by the employer."24 The Court also looked at specific statutory exemptions from the definition of wages for FICA purposes and the statutory history of FICA and concluded that the specificity of those exemptions and the statute's history reinforced the broad nature of FICA's definition of wages.
The next question the Court faced was whether Sec. 3402(o), which on its face relates only to federal income tax withholding, somehow alters or is a limitation on the meaning of "wages" for FICA purposes. Quality Stores had argued, and the Sixth Circuit had agreed, that the "as if they were wages" language of Sec. 3402(o) implied that the definition of wages for income tax withholding does not include severance payments and thus, by extension, does not include severance payments for FICA purposes.
The Court first looked at the definition of wages under the statutes relating to federal income tax withholding and noted that the definition was broad and was consistent with FICA's definition of wages. Next, the Court examined the specific statutory exemptions from the definition of wages, noted that severance payments are not specifically exempted, and found that the exemptions reinforce the broad scope of the term "wages." The Court disagreed with the Sixth Circuit's conclusion that the "as if" language means that all SUB payments are "non-wages." Instead, the Court reasoned that the "as if" language is in all respects consistent with the proposition that at least some severance payments are wages.25
The Court next looked at the regulatory and historical backdrop against which Sec. 3402(o) was enacted and the problem it was intended to address, namely that terminated employees could owe substantial federal income taxes at the end of the year as a result of the IRS's not treating some SUBs as wages, which made them exempt from income tax withholding. The Court found that Congress enacted the provision simply because it believed that the best way to permanently solve this problem associated with SUBs was by treating all severance payments as wages requiring withholding. Thus, the Court concluded that, viewed in the appropriate historical context, Congress's adoption of Sec. 3402(o) did not intend to narrow the definition of "wages" under FICA to exclude all severance payments from that definition. Instead, it merely provided a solution to a specific withholding problem.
Finally, the Court explained that treating severance payments as FICA wages was consistent with its holding in Rowan. The Court stated that the major principle recognized in Rowan was "that simplicity of administration and consistency of statutory interpretation instruct that the meaning of 'wages' should be in general the same for income-tax withholding and for FICA calculations." Therefore, since severance payments fell within the broad definition of wages for income tax withholding and FICA, treating severance payments as wages for FICA was in accord with this principle. According to the Court, "To read Congress' command to withhold severance payments as an implicit overruling of the broad definition of wages in FICA would disserve the statutory text and the congressional interest in administrative simplicity deemed controlling in Rowan."26
After a number of years of uncertainty, the Supreme Court's decision in Quality Stores has definitively resolved the issue of whether severance payments are subject to FICA. In general, severance payments are FICA wages, and FICA must be withheld from them. However, as the Supreme Court pointed out in its opinion, the IRS still provides in Rev. Rul. 90-72 that severance payments tied to the receipt of state unemployment benefits are exempt from both federal income tax withholding and FICA. Because the severance payments by Quality Stores were not linked to state unemployment benefits, the Court did not reach the question whether the IRS's current exemption is consistent with the broad definition of wages under FICA.
1 Rowan Cos., Inc., 452 U.S. 247 (1981). In Rowan, the Supreme Court held that an IRS regulation that defined wages differently for income tax withholding than for FICA and FUTA purposes, when determining whether meals supplied for an employer's convenience were taxable, was invalid.
2 CSX Corp., 518 F.3d 1328 (Fed. Cir. 2008), aff'g in part and rev'g in part 71 Fed. Cl. 630 (2006) and 52 Fed. Cl. 208 (2002).
3 Quality Stores, Inc., 693 F.3d 605 (6th Cir. 2013).
4 Quality Stores, Inc., 134 S. Ct. 1395 (2014), rev'g and remanding 693 F.3d 605 (6th Cir. 2013).
5 Internal Revenue Code Chapter 24, Collection of Income Tax at Source on Wages.
6 Sec. 3402(o)(1).
7 Rev. Rul. 65-251, Rev. Rul. 71-408, and Rev. Rul. 74-252.
8 For purposes of the CSX court's decision and this article, taxable "wages" for purposes of FICA or taxable "compensation" for purposes of the RRTA have the same meaning. As a result, this article, like the Court of Appeals, focuses on the analysis of "wages" for purposes of FICA.
9 CSX Corp., 71 Fed. Cl. 630 (2006) and 52 Fed. Cl. 208 (2002).
10 CSX Corp., 518 F.3d 1328 (Fed. Cir. 2008).
11 Sec. 3402(o)(2)(A).
12 Sec. 3402(o)(1) (flush language).
13 After a careful analysis of the terms of the various severance plans adopted by CSX, the lower court found that some of CSX's plans met the definition of a SUB and, thus, were not taxable under FICA but that other plans did not meet the definition of a SUB and were, therefore, taxable under FICA (CSX Corp., 52 Fed. Cl. 208 (2002)).
14 Quality Stores, Inc., 693 F.3d 605 (6th Cir. 2012), rev'd and remanded, 134 S. Ct. 1395 (2014).
15 Quality Stores, Inc., 383 B.R. 67 (Bankr. W.D. Mich. 2008).
16 Quality Stores, Inc., 424 B.R. 237 (W.D. Mich. 2010).
17 Quality Stores, Inc., 693 F.3d 605 (6th Cir. 2012).
18 Id., slip op. at 7, quoting Social Security Bd. v. Nierotko,327 U.S. 358, 365-66 (1946).
19 Id., citing Coffy v. Republic Steel Corp.,447 U.S. 191, 200 (1980).
20 Id., slip op. at 8, quoting Sec. 3402(o) (emphasis added by the court).
21 Id., slip op. at 8, quoting Sec. 3402(o) (emphasis added by the court).
22 Id., slip op. at 21.
23 Quality Stores, Inc., 134 S. Ct. 1395 (2014), rev'g and remanding 693 F.3d 605 (6th Cir. 2012).
24 Id., slip op. at 5, quoting Social Security Bd. v. Nierotko,327 U.S. 358, 365-66 (1946).
25 Id., slip op. at 8-9, citing CSX Corp., 518 F.3d at 1342 (Fed. Cir. 2008).
26 Id., slip op. at 14.
|Gary Sanders is a clinical instructor of business law and accounting, and Darlene Pulliam is Regents Professor and McCray Professor of Business, both at West Texas A&M University in Canyon, Texas. For more information about this article, contact Prof. Pulliam at email@example.com.