EXECUTIVE SUMMARY

AS A RESULT OF THE CSX DECISION, SOME COMPANIES may be due refunds of Social Security, Medicare and unemployment taxes they had made on severance payments to separated employees following a layoff or termination. The court ruled such amounts are supplemental unemployment compensation benefits (SUCBs) and thus are not wages subject to payroll taxes. FOR A COMPANY TO BE ELIGIBLE, IT MUST HAVE PAID severance benefits to employees under an established reduction-in-force plan. Since the right to amend payroll tax returns under IRC section 6511 is limited to three years, CPAs should act quickly to help clients and employers collect the money due them. CPAs SHOULD REVIEW COMPANY PAYROLL RECORDS to determine the amount of potential SUCBs. Assuming the amount is enough to justify the cost of the refund process, accountants should make the necessary computations, assemble the needed documentation and file the required amended payroll tax returns. COMPANIES NEED TO DECIDE WHETHER THEY WILL APPLY for the employees’ portion of the tax overpayment. Without help from their former employer, most terminated workers will have an almost impossible task of getting refunds on their own. The IRS requires companies to gain written authorization from employees to request refunds on their behalf. AFTER COMPANIES RECEIVE THEIR REFUNDS, they should place the funds in escrow to give the IRS time to audit the amended returns. This includes the monies due to employees. Failure to do so could result in significant penalties for the company if the IRS asks for its money back.

DOUGLAS LETSCH, CPA, is a consultant on corporate finance and tax strategies in Bloomington, Indiana. He also is an adjunct professor at Walden University in Minneapolis, where he is pursuing his PhD in finance. His e-mail address is dlets001@waldenu.edu.

or years the IRS has insisted companies collect and pay Social Security, Medicare and unemployment taxes on all severance payments they made to former employees after a layoff or termination. About 13 years ago, CSX Corp. challenged this established practice and IRS interpretations. The company had been company had been withholding and paying the employee and employer’s shares of employment taxes on several types of severance payments. Then it had filed amended returns and had requested refunds. The IRS disallowed the claims so CSX took the agency to court.

It was not an easy task and it took CSX many years, but on April 1, 2002, the U.S. Court of Federal Claims issued its opinion in CSX Corp., 52 Fed. Cl. 208 (2002). It held that payments a company makes to involuntarily terminated employees under a reduction-in-force plan are supplemental unemployment compensation benefits (SUCBs) and thus not “wages” for purposes of Social Security, Medicare and unemployment taxes.

The statutory time now has passed and the IRS no longer can appeal the decision. It remains silent instead of issuing an action on decision (AOD) indicating what direction its acquiescence in the case will take. The IRS national media relations office would not comment on CSX or any future agency action. The IRS, however, has issued some guidance in Supplemental Circular E, demonstrating its intent to follow parts of CSX. This article explains how CPAs can help their employers and clients get refunds of previously paid employment taxes.

ACT QUICKLY
With every passing moment a company could be losing money. Since IRC section 6511 limits the right to amend payroll tax returns to three years, CPAs will find that sitting on the fence waiting for IRS clarification of its position only will hinder refund possibilities. I successfully filed amended returns on behalf of several clients that received refunds of overpaid Social Security and Medicare payments on severance payments considered SUCBs. This suggests other companies can take similar action.

CPAs should help employers or clients that have had substantial employee terminations and layoffs consider how CSX affects those payments and whether the company is eligible to file amended returns. By filing such returns the company gives itself a protective claim on overpaid FICA and FUTA taxes that also stops the amended-return time clock.

Filing amended returns isn’t as simple as it might first seem. Even CPAs who have been preparing payroll tax returns for years should exercise extreme caution. Here are some guidelines accountants can follow for their clients or employer.

Perform an initial review of the client’s or employer’s payroll records to determine the amount of potential SUCBs. If the amount of SUCBs the company paid over the last three years, calculated at 7.65% (maximum employer portion of Social Security and Medicare taxes), is enough to consider the project, then the CPA should undertake further analysis.

Search for all terminations over a four-year period beginning in 1999 and determine the amount of SUCBs the company paid after termination and during the three-year statutory period. This extended period means a company could have SUCBs on one separated employee in two or more different years. Since many companies pay severance as an annuity, CPAs must check to see whether the company made any payments within the statute of limitations that it may have agreed to earlier.

Document that severance payments the company made were in fact SUCBs. This usually involves a human resources (HR) audit and may entail a review of each person’s payroll records and the corporate payroll and benefit policies. While HR does this audit, the finance and IT departments need to gather data and compute actual differences in Social Security and Medicare wages and taxes. Here are some additional questions CPAs need to ask:

Did the company pay SUCBs after the separated employee reached the maximum Social Security wage base for that year? If so, the Social Security tax rate would not apply. Medicare, however, would. Remember that the Social Security rate changes from year to year.

How much of the severance is actually qualified according to new IRS guidelines and CSX?

Did the company pay SUCBs in more than one calendar year? In this case the Social Security wage base would change and a higher rate would apply in the second year.

The company must decide whether it will apply for the former employee’s portion of the overpayment. Without company help, terminated employees will have an almost impossible task of getting their refunds. Most companies ask for both the employer and employee portions of overpaid payroll taxes.

If the company decides to help employees, the IRS requires it to gain written permission from each one to file amended returns and seek refunds on their behalf. The employee also must certify that he or she will not attempt a refund on his or her own.

When a company contacts separated employees, its phones will light up with calls and questions. CPAs should be prepared to spend at least five minutes on each call. In-house CPAs should determine whether outsourcing this task would be a better alternative.

After accumulating the responses of separated employees, CPAs should recalculate the employee portions of the refunds, verify all calculations and then file the amended returns. For most employers this includes form 941C, with a corrected 941 for each amended quarter. CPAs need to be careful to fully justify filing the amendment; demonstrating proof of SUCBs is essential. The proper citation along with copies of plans, contracts and handbooks can make the difference between success and an IRS review.

All that’s left is to wait for an IRS response. Refunds generally take up to six weeks but could stretch much longer depending on the amounts and number of employees involved. THE WAITING PERIOD Once the IRS issues a refund, the company should hold the proceeds, giving the IRS time to audit the amendment. During this waiting period, CPAs should recommend the employer place these funds in escrow, thereby averting legal issues that may arise from commingling assets. If the transaction involves employee trust funds, the Internal Revenue Code’s 100% penalty provisions will apply. Thus CPAs should exercise extreme caution to avoid this. The amount of time to hold funds in escrow is a company decision since the IRS can still audit amended returns after processing refunds. The maximum time a company can hold refunds before distributing them is three years. The risk a company faces by making distributions before three years is that the IRS will ask for its money back and may require it to repay funds sent to past employees. Here is where training and experience can help; how accurately CPAs perform the tasks described above is essential to limiting this waiting period. The money will earn interest for whatever time a company decides to hold the funds.

PRACTICAL TIPS TO REMEMBER CPAs should review employee termination and layoff records carefully to see whether payments the company made to employees qualify as SUCBs. To qualify, the employer must have made the payments under a reduction-in-force plan evidenced by an employment contract, employee handbook or other agreed-upon company action involving a cut in staff. Accountants should be sure to make the computations carefully. If the company made payments to a terminated employee over two tax years, a different Social Security tax rate and wage base may have applied. The same caution applies with employees who had earned more than the maximum wage base. In this case only Medicare taxes would apply to earnings over the maximum. After the company receives its tax refund, CPAs should recommend it place the funds in escrow and not commingle them with any other money. This gives the IRS time to audit the amended payroll tax returns. Improper handling of employee trust fund assets can subject the company to the Internal Revenue Code’s 100% penalty provisions.

Once the company has the refunds in hand and distributes them to past employees, it’s time to complete the remaining paperwork. CPAs will need to prepare a W-2C and a form 1099-INT for each former employee showing the change to the original W-2 and the amount of interest the company received from the IRS (yes, the IRS will pay interest on overpaid SUCB taxes), plus the interest from the escrow accounts. At the appropriate time they must file the originals with the Social Security Administration and the IRS and mail copies to each employee. The company’s CPAs should prepare these forms but hold off on filing them until the company actually distributes the funds. If the process goes into another calendar year, CPAs need to use the correct form 1099-INT for that year.

IT’S UP TO YOU
The refund process may be onerous, but as most CPAs know, working with the IRS generally is not easy. However, a substantial refund will make the time spent worthwhile. CPAs should encourage their employers and clients to explore this opportunity on behalf of themselves and terminated employees—both of whom could benefit from extra dollars in their pockets.