IRS Rekindles Compliance • Arbitration and Mediation Update • IIR Pilot Becomes Permanent • IRS Clarifies “Involuntary” Separation

Editor:

Mark H. Ely, J.D., CPA
Partner
Washington National Tax
KPMG LLP
Washington, DC

Editor's note: Mr. Ely is former chair of the AICPA Relations with the IRS Committee. Mr. Dougherty, is the current chair, and Mr. Dolan and Ms. Pflieger are members of that committee.

Expect Renewed IRS Compliance Efforts

The tax administration pendulum appears to be swinging back to the middle toward enforcement, resulting in an increase in IRS examinations and collections.

With the enactment of the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSRRA), the Service found its resources consumed by the dual demands of restructuring and reform. Conversion from its traditional geographical and functional structure to the four new business divisions consumed huge amounts of attention and resources. In addition, its renewed emphasis on improved customer service and efforts to implement the many requirements imposed by the IRSRRA necessitated a wholesale reassignment of staff from traditional field enforcement work (i.e., audits and collections) to customer service and IRSRRA initiatives. Most field personnel also participated in myriad mandatory IRSRRA-related training, which consumed additional work hours that would have ordinarily been devoted to traditional daily tasks.

Not surprisingly, the cumulative diversion of resources resulted in a significant reduction in audit and collection. However, because its four new business divisions are now operational, the IRS can reallocate its resources to deal with taxpayer compliance. In addition, with the recent Congressional hearings urging the Service to reinvigorate its enforcement activities, tax practitioners should expect an increase in enforcement initiatives.

Audit Coverage

The manner in which the IRS conducts its taxpayer audits is frequently focused on by the press and Congressional oversight. For example, periodically, Congress, the press and the Service evaluate the rate at which the IRS "audits" taxpayers in various economic strata, drawing conclusions about whether audit coverage has increased or decreased from one year to another. In recent years, the press has enjoyed reporting that the Service's audit rate for the wealthiest Americans has fallen, while the rate has risen for low-wage-earning taxpayers. Often overlooked in that "analysis," however, is the fact that Congress has mandated the IRS to aggressively pursue audits of earned income tax credit (EITC) claims, which increases the audit rate for taxpayers entitled to the EITC.

In absolute terms, the audit-coverage rate has been decreasing since the mid-1990s. For example, the total individual field audit rate (i.e., audits done by revenue agents) has fallen from 0.66% in 1996 to 0.16% in 2001. During that same period, individual taxpayers earning more than $100,000 have seen their audit rate fall from 2.08% to 0.49%. On the corporate side, the number of field audits of entities with less than $10 million in assets declined from 45,091 in 1996 to 13,169 in 2001. The largest corporate audits have shown a less dramatic decline, with a fall in field audits from 12,586 in 1996 to 8,465 in 2001.

The Service is planning to increase audits in most economic sectors. This plan relies on reengineering audit processes, redirecting resources and assimilating 733 newly hired revenue agents—the first installment of such hires in many years.

The Tax Exempt and Government Entities (TEGE), Large and Mid-Size Business (LMSB) and Small Business/ Self Employed (SBSE) divisions are all in the midst of reorienting their examination resources. TEGE is already operating under its new strategy, which involves centralizing return selection and key decision making in Dallas.

LMSB has actively sought input from its constituents on how best to save time, yet also refine the focus of its audits. Its goal is both to reduce the resource requirements of its coordinated industry cases (CICs) and expand its presence into more mid-sized businesses and passthrough entities. As a tool in its stepped-up evaluation of pass-through entities, the IRS will soon have access to the results of its first-ever comprehensive matching of Schedules K-1; nearly 17 million were issued for tax year 2000.

The SBSE audit program was hardest hit by resource diversions. However, many of SBSE's enforcement personnel have now returned to their regular positions and many of the newly hired revenue agents have been assigned to SBSE in an effort to replace the agents lost to attrition. SBSE also undertook a comprehensive review of its audit processes. It plans to implement a variety of changes designed to leverage auditors better across a spectrum of cases that reflect some of the lowest overall levels of compliance, yet have traditionally received only sparse audit attention.

National Research Program

The Service currently selects returns to be audited based on a formula derived from its historical Taxpayer Compliance Measurement Program (TCMP). The TCMP draws its data from an ongoing series of intensive line-by-line audits done on a selected sample of returns. During the mid-1990s, in the face of severe criticism from key Congressional leaders, the IRS suspended the TCMP. In the intervening years, however, without refreshed data from the TCMP or a comparable source, the precision of the return-selection formula has eroded. As the data aged, "no-change" rates rose. Rising no-change rates are a needless burden on audited taxpayers and increase the Service's opportunity costs, because sparse audit resources are diverted from noncompliant returns.

To counteract rising no-change rates, the IRS intends to launch the National Research Program (NRP) in 2002. Data from the program will be used to refresh the Service's overall compliance measurements and return-selection formula.

In the initial phase, the NRP will focus on approximately 50,000 of the 132 million 2001 individual returns filed. Of that number, about 2,000 "calibration" audits will be performed. These audits will approximate the intensity of prior TCMP audits, but the IRS promises that it will not generally require taxpayers to provide line-by-line substantiation. The bulk of the NRP will consist of "partial audits" of 30,000 returns. In these audits, the Service plans to develop enough preliminary information so that the actual audits can focus only on items that the IRS cannot independently verify. NRP audits should take roughly the same amount of time to complete as traditional individual audits, in contrast with TCMP audits, which usually took twice that amount of time.

Collection

In addition to the impact felt from the diversion of collection resources to other work, the collection workload itself was dramatically affected by the IRSRRA. Collection due process (CDP) procedures (which provided new rules for the processing and appeal of liens and levies) introduced new players and increased the time and resources necessary for Collections to close a case. The liberalized Installment Agreement and Offer-in-Compromise (OIC) provisions added additional steps and time to the collection process. Similarly, increased levels of review and approval for seizures and sales also added time and complexity to cases.

Beyond the specific process changes brought about by the IRSRRA in general, Section 1203 caused collections to ebb. This section (often referred to as the "10 deadly sins") provides 10 acts, which, if committed by a Service employee, result in mandatory dismissal. One of the "sins" is harassing taxpayers. Many employees in Collections feared being accused of harassment if they pursued their cases too vigorously. Despite management assurances to the contrary, many chose to avoid risk and were less aggressive.

Backlogs still exist in the number of CDP appeals and OICs awaiting resolution, but plans are in place to improve both processes. The original Section 1203 "chill" also seems to have abated; IRS reports show that collection activity has increased and is expected to continue to do so in the coming year. On a related note, Service officials recently testified that the IRS was again considering the merits of using private contractors to collect certain types of delinquent accounts.

Criminal Investigation

The Criminal Investigation Division (CID) focuses on the most egregious forms of taxpayer noncompliance. It has increased the resources it applies to investigations and the number of cases it investigates in traditional tax-non-compliant areas. Perhaps because the CID underwent less fundamental re-structuring than some other divisions of the Service, it has been able to orchestrate a series of well-publicized initiatives addressing such areas as employment tax fraud, a variety of frivolous claim scams and EITC fraud.

The CID is also integral to the Service's recently publicized strategy to uncover the identities of U.S. citizens using credit cards to access what is allegedly substantial amounts of unreported income located in offshore bank accounts. As an antidote to a perceived reduction in cases arising from traditional fraud referral, the CID has also reenergized its fraud referral process, by encouraging the operating divisions to identify dedicated fraud coordinators and creating national Lead Development and Fraud Detection centers. Both of these strategies are designed to increase the number and quality of fraud referrals that derive from intentional noncompliance.

Institutionalizing ADR Initiatives

In addition to reviving traditional audit and collection enforcement techniques, the IRS continues to expand its use of alternate dispute resolution (ADR) methods. Following successful pilots, both the Pre-filing Agreement (PFA) and the Industry Issue Resolution (IIR) programs have been made permanent. A more recent initiative, LMSB's Fast Track Dispute Resolution Pilot, is the newest ADR tool. Unveiled in December 2001 in Notice 2001-67, the new procedure involves Appeals Officers mediating or settling issues or both, while the taxpayer's returns are still under LMSB's jurisdiction. Approximately 19 of the 38 cases accepted into this new program have already been successfully resolved, and the other 19 are pending. In addition, LMSB is evaluating 24 other cases for inclusion in the program. Initial reactions from both taxpayers and the Service have been positive, and substantial issues have been resolved at a fraction of the normal time and cost. The IRS remains convinced that PFA, IIR and "Fast Track" will allow it to refocus its efforts and reduce the amount of audit time traditionally applied to the largest (CIC) examinations, while enabling it to expand its audit presence in lower coverage areas.

Conclusion

As the Service continues to modernize its computer systems and business practices, old techniques for encouraging voluntary compliance will give way to new approaches. At some level, however, an effective enforcement program is likely to remain a powerful compliance incentive for many and a noncompliance deterrent for others. Tax professionals should expect to see the IRS increase its conventional audit and collection activity, while it simultaneously seeks new opportunities to advance compliance across-the-board.

From Michael P. Dolan, National Director, IRS—Policies & Dispute Resolution, Tax Controversy Services, Washington National Tax, KPMG LLP, Washington, DC

An Inside Look at the Arbitration and Mediation Programs

The mission of IRS Appeals is to resolve tax controversies without litigation, in a manner both fair and impartial to the government and the taxpayer, and in a manner that will enhance voluntary compliance and public confidence in the Service's integrity and efficiency. Appeals has developed two programs to help achieve this mission—nondocketed arbitration and post-appeals mediation. These are alternatives to normal settlement negotiations between Appeals and a taxpayer, when a settlement cannot be reached. Both programs employ a neutral third party to assist the parties in resolving outstanding issues. The main difference between the programs is that the findings in arbitration are binding, while the findings in mediation are not.

Arbitration

Program description. Nondocketed arbitration is an optional process that uses an arbitrator to render a decision binding on both parties. Sec. 7123(b)(2) established the pilot program for arbitration, and Ann. 2000-4 described it. Issues eligible for arbitration are those not resolved under normal Appeals procedures. Arbitration may be used only to resolve factual issues that can be severed from the other issues in a case. A factual issue is one that can be resolved solely on a finding of fact. Any interpretation of law, regulation, ruling or other legal authority must be resolved and agreed on by the parties, for the issue to be eligible for arbitration.

According to Ann. 2000-4, arbitration may not be used for:

• Cases in which arbitration is inappropriate under either 5 USC Section 572, General Authority, or 5 USC Section 575, Authorization of Arbitration;
• Issues involving the substantiation of expenses under Sec. 162 or 274;
• An issue designated for litigation or docketed in any court;
• An Industry Specialization Program (ISP) issue or an Appeals Coordinated Issue (ACI); or
• An issue for which the taxpayer has filed (or intends to file) a request for competent authority assistance.

Appeals' arbitration program is a nondocketed procedure, not meant to become a legal process. If a taxpayer wants a legal process, the courts or docketed arbitration are available, both handled by the IRS Chief Counsel's Office.

Requesting arbitration. Either the taxpayer or Appeals may request arbitration, but both parties must agree to arbitrate for the case to be accepted in the program. Taxpayers should send their request to the Team Case Leader/Appeals Officer responsible for the case. The Team Case Leader/ Appeals Officer will prepare a written recommendation for action on the request and forward the request and recommendation to his immediate supervisor for approval. If the supervisor approves the acceptance of the case for arbitration, he will then forward the documents to the Appeals Area Director for final approval. In addition, the National Chief of Appeals Office will be consulted prior to a final determination of approval. Normally, this final determination is made within 30 days of the Team Case Leader/Appeals Officer receiving the request. If the request is approved, Appeals LMSB Operations will schedule an appointment with the taxpayer to discuss the arbitration process. If the request is denied, the taxpayer could ask for a conference with the Appeals Area Director to discuss the denial.

Arbitration process. Once the arbitration request has been approved, the parties will enter into a written arbitration agreement. The agreement's terms are negotiated at a conference provided by Appeals LMSB Operations. The agreement will provide guidance to the arbitrator, including (but not limited to) the following:

• An outline of the law;
• The authorities to which the arbitrator can refer;
• The parameters to work within;
• The additional information available; and
• The sources of additional information.

The agreement will contain (among other items) the participants' names, the issues, the site, the date and the agenda for arbitration. Sometimes, the agreement will contain a settlement range within which the arbitrator must work. The Service is also considering the inclusion of a timeframe in the agreement, to ensure no unnecessary delays in the process by either party.

The parties to an arbitration process include the taxpayer, his authorized representative, Appeals, the arbitrator and an administrator. The administrator is from Appeals LMSB Operations or the organization providing the arbitrator. The parties must communicate with the arbitrator through the administrator, unless both are present. The administrator and the arbitrator will explain the arbitration process to the parties and make clear that no ex parte communication may occur between either of the parties and the arbitrator. IRS counsel may also play a role in the arbitration process, by assisting Appeals in drafting the arbitration agreement, developing strategies and presenting the issue at the arbitration hearing. Experts may also be brought into the arbitration process. However, both parties must agree to their admittance.

The taxpayer and Appeals will select an arbitrator with the assistance of the administrator. This arbitrator may be from Appeals or may be non-Service. Usually, the arbitrator is from outside the IRS. The taxpayer and the Service must agree on the arbitrator selection. Appeals arbitrators may not report to the same manager as the Appeals Officer handling the case. If an Appeals arbitrator is used, National Office Appeals will pay the arbitrator's expenses. If a non-IRS arbitrator is employed, the taxpayer and National Office Appeals will share the expenses equally.

One of the main benefits of arbitration is that the process is confidential. All parties will have access to the taxpayer's returns or return information on the issues being considered. However, they may not voluntarily, or through discovery or compulsory process, disclose any information regarding the arbitration process.

Conclusion of process. At the end of the arbitration process, the arbitrator will prepare a written report and submit it to the parties and the administrator. The arbitrator's findings are final; neither party may appeal the findings nor contest them in any judicial proceeding. Appeals will use established procedures to close the case.

Pilot program. The two-year pilot program began on Jan. 18, 2000. Thus far, six taxpayers have requested arbitration. Of these, two were rejected because they did not qualify for the program. Four are in process; two of these are expected to settle prior to arbitration. Currently the Service is accepting requests for this program.

Future of the program. In the future, the IRS is considering the inclusion of ISP issues in the program, when review and concurrence by the Appeals ISP Coordinator is not mandatory. These issues will be considered for arbitration on a case-by-case basis.

Mediation

Description of program. Mediation is an optional nonbinding process that allows the taxpayer and Appeals to continue to negotiate a settlement with the assistance of a neutral third-party mediator. Anns. 95-86 and 97-1 contain the procedures that taxpayers used in the past to request mediation. Prior to Ann. 98-99, mediation was only an option for taxpayers with issues in Coordinated Industry Cases assigned to Appeals Team Case Leaders. Ann. 98-99 expanded the program to include the use of mediation for factual issues, such as valuation, reasonable compensation and transfer pricing, that involve adjustments of at least $1 million. These issues must already be in the Appeals administrative process. Mediation may not be used to resolve:

• An issue designated for litigation or docketed in any court;
• An ISP issue or an ACI; or
• An issue for which the taxpayer has filed (or intends to seek) competent authority assistance.

The two-year test period for the expanded issues began on Nov. 16, 1998. Ann. 2001-9 expanded the test period for mediation for an additional year beginning on Jan. 16, 2001. While the test program has officially ended, the Service is continuing to accept mediation cases. After the test program, mediation will most likely be extended to additional issues and taxpayers.

Pilot program. The results of the mediation program, from its start in 1995 through March 2002, have been positive. While the program is not designed for everyone, it is definitely an option taxpayers should consider. The number of requests has steadily increased since the program was expanded in 1998 to include a broader range of cases. The following is a summary of the test program's results (as of March 22, 2002):

The details of these requests are:

• 13 resolutions;
• 22 resolved prior to mediation;
• 7 not resolved;
• 1 withdrawal;
• 1 returned to Examinations because it was a premature referral;
• 15 in process; and
• 22 nonqualifications, which did not meet the program's eligibility criteria.

The IRS has used 54 mediators, of which 24 were non-Service and 30 were Appeals mediators. The breakout of the number and type of mediators per case is:

• 2 cases with 1 outside mediator per case;
• 3 cases with 1 Appeals mediator;
• 3 cases with 2 Appeals mediators per case; and
• 21 cases with co-mediators (non-IRS and Appeals—one case used 2 outside mediators along with an Appeals mediator).

Appeals currently has 52 mediators trained to participate in this program.

Future of the program. A program is being designed currently that would dramatically expand the number of taxpayers eligible to participate in the mediation program. Proposed changes include:

• Eliminating the $1 million limit to qualify for the mediation program.
• Expanding the program to include ACI and ISP issues.
• Including timeframes when the request is made to ensure that there are no unnecessary delays in the process.
• Assigning an Appeals mediator to all cases. Appeals mediators will be selected within the case's geographic area, unlike the current practice of choosing someone from outside the area. This could result in a taxpayer not having any input in the selection of the Appeals mediator, as a possibility exists that there is only one trained mediator in the geographic area. In this situation, if a taxpayer has serious concerns about the mediator selected, Appeals will take into account these concerns and will consider using an Appeals mediator from another area. Both parties still have to agree to the mediators.
• If the taxpayer elects to use an outside mediator, the taxpayer will pay the full cost, rather than the current practice of sharing the fees with the Service. This should greatly reduce the time between requesting mediation and the actual mediation process, as the onerous government contracting procedures will no longer be necessary; if an outside mediator is selected, he will be a co-mediator with the Appeals mediator.

Note: Only two cases have used solely outside mediators, and these occurred early in the program.

Conclusion

In developing these programs, the IRS continues to encourage resolution of disputes without the prospects of prolonged litigation. Arbitration and mediation are unique services offered to taxpayers to assist them in the resolution of their issues and should be considered by taxpayers on a case-by-case basis.

From Jim Dougherty, Director, and Rona Faust, Senior Manager, Tax Controversy Services, Washington National Tax, Deloitte & Touche LLP, Washington, DC.

Special thanks to Earl Blanche, Jr., Director, Appeals LMSB Operating Unit, and Sandy Cohen, Senior Program Analyst, for their generous time and valuable input in the development of this item.

Successful IIR Pilot Program Becomes Permanent

In its continuous effort to resolve issues earlier in the examination process, the IRS introduced the Industry Issue Resolution (IIR) program in 2000, for frequently disputed issues affecting many taxpayers. The IIR pilot program was established under Notice 2000-65. It proved to be a huge success, and the Service adopted the program permanently in 2002 (Notice 2002-20).

What is the Program About?

The IIR program was designed to provide guidance on common disputes. Its goal was to reduce the cost and burden of settling disputes for both taxpayers and the IRS, as well as to curtail the number of disputes that occur during post-filing examinations, thus cutting back on the time needed for audits.

The permanent IIR program is open to all business taxpayers, unlike the pilot program, which the Service restricted to only Large and Mid-Size Business (LMSB) Division taxpayers. The LMSB and Small Business/Self Employed (SBSE) divisions will share responsibility for operating the program.

In selecting the types of issues to include in the IIR program, the IRS solicits input from individuals, industry associations and other groups. In selecting program issues, the Service considers whether the issues are appropriate, the likelihood that it can provide timely guidance and the availability of necessary staff and resources.

An appropriate issue generally has two or more of the following characteristics:

• Uncertainty exists as to the correct tax treatment in a given situation.
• Uncertainty results in frequent, often repetitive, examinations of the same issue.
• Uncertainty results in a significant burden on the taxpayer.
• The issue is material and affects a significant number of taxpayers, either within an industry or across industry lines.
• A factual determination is a major component of the issue.

Inappropriate issues include:

• Issues unique to only one taxpayer or a small number of taxpayers.
• Issues under the jurisdiction of the Commissioner, Tax Exempt, and Government Entities Divisions (e.g., employee plans).
• Issues about transactions that lack a bona fide business purpose or for which taxpayers significantly reduce or specifically avoid paying Federal taxes.
• Issues involving transfer pricing or international tax treaties.

After reviewing the issues, the Service, the Office of Chief Counsel and Treasury select which ones they will include in the IIR program. Taxpayers do not have any input in this process.

Next, a team of appropriate professionals from the LMSB and the SBSE divisions, the Office of Chief Counsel, Appeals and Treasury reviews each issue and offers a resolution. When necessary, the team consults outside experts. An official traditionally responsible for settling disputes must approve the team's solution.

In reviewing an issue, the team may need additional information from the taxpayer (or group of taxpayers). It must request this information under the requirements of the Federal Advisory Committee Act. In addition, the team may also ask to inspect the taxpayer's books and records. This is voluntary; a review is not an examination and a taxpayer may still be subject to another review of its books and records during a later audit. However, during a team review, taxpayers are expected to disclose any information necessary to reach a resolution. This information may be subject to disclosure under the Freedom of Information Act. The taxpayer can provide information to the team, but it cannot participate in negotiations or in decisions.

Once the team reviews an issue and an official approves a recommendation, the IRS publishes guidance (most likely in the form of a revenue ruling or a revenue procedure), informing taxpayers of the proper treatment for reporting future returns (or in certain cases, prior-year returns).

What Are the Pros and Cons of the Program?

Like all programs, there are both good and bad points. The benefits of the IIR program include:

• Resolution of the same issue for a large number of taxpayers;
• Establishment of a consistent IRS position;
• Reduction in the cost and burden of disputing issues for both taxpayers and the Service;
• Elimination of tax-treatment un-certainty; and
• Elimination of financial-statement uncertainty.

The downside to the program is that:

• An industry settlement may be unfavorable to a particular company or group of companies.
• The IRS is less likely to consider an individual taxpayer's unique facts on a case-by-case basis after making an agreement with an industry. (For this reason, it is important for taxpayers or their representatives to provide input during a review process.)
• Taxpayers are not involved in the process, aside from providing documentation, and they do not have any decision-making authority.

Results of the Pilot Program

The pilot program was available solely to taxpayers in the LMSB division. Twenty-four taxpayers asked to take part in the pilot program and the IRS selected seven. Of these taxpayers, five issues were resolved as of April 25, 2002. The issues and related published guidance are as follows:

• Taxability of demonstrator automobiles provided to automobile salespersons (Rev. Proc. 2001-56);
• Clarification of bad debt charge-offs and conformity election for banks (Rev. Rul. 2001-59);
• Depreciation of golf course construction costs (Rev. Rul. 2001-60);
• Safe-harbor method of accounting for smallware costs for restaurant and tavern operators (Rev. Proc. 2002-12); and
• Treatment of impact fees and similar costs incurred during the development and construction of depreciable real estate (Rev. Rul. 2002-9).

The two remaining issues with guidance yet to be published are:

• Treatment of amounts paid by an employer to an employee for the rental of rigs and other equipment; and
• Determination of recoverable re-serves for oil and gas for cost-depletion purposes.

Guidance on these two issues is expected this year.

Conclusion

In recent years, the IRS has made a concerted effort to give taxpayers various options for resolving issues prior to a post-filing examination. The IIR program is an example of this effort. Based on the pilot's success, the IIR program appears to be a beneficial dispute-resolution tool for both taxpayers and the Service. Taxpayers with recurring or industrywide issues should consider submitting them to the IRS for inclusion in the IIR program. The best way to do this is through an industry group. For further information on how to bring an issue to the IRS's attention and on the IIR program in general, contact Susan Blake, Senior Program Analyst, of the LMSB Pre-filing and Technical Services Office, at (202) 283-8414.

From Jim Dougherty, Director, and Rona Faust, Senior Manager, Tax Controversy Services, Deloitte & Touche LLP, Washington, DC

Involuntary Severance Benefits Not Subject to FICA Tax

Severance pay is generally considered compensation for services rendered and as such, wages subject to income tax and FICA tax withholding. The IRS has clearly stated this position in Regs. Sec. 31.3401(a)-1(b)(4), which states, "any payments made by an employer to an employee on account of dismissal, that is, involuntary separation from the service of the employer, constitute wages regardless of whether the employer is legally bound by contract, statute, or otherwise to make such payments," as well as in Rev. Rul. 75-44, for FICA taxes.

However, in CSX Corp., 4/1/02, the Court of Federal Claims concluded that certain severance payments were not subject to FICA taxes. While the definition of wages in Sec. 3121 for FICA tax purposes usually mirrors the definition of wages for income tax withholding purposes in Sec. 3401, only under Sec. 3402(o) are "supplemental unemployment compensation benefits" subject to income tax withholding; no similar specific exception exists for Sec. 3121 purposes. Therefore, the court concluded, "supplemental unemployment compensation benefits" are not subject to FICA taxes.

Note: The CSX decision occurred just two weeks prior to the close of the statute of limitations for all four quarters of 1998 employment tax returns, which caused taxpayers to file a flurry of protective claims with the IRS by April 15, 2002. Whether employers will do the work necessary to perfect those claims will depend on the future of the CSX decision.

Under Sec. 3402(o), an employer must withhold income taxes from "supplemental unemployment compensation benefits." Such benefits are:

[A]mounts 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 conditions, but only to the extent such benefits are includible in the employee's gross income.

Traditionally, the Service has sought to restrict the types of payments considered supplemental unemployment compensation benefits. In Rev. Rul. 90-72, it ruled that such benefits must be linked to the receipt of state unemployment compensation and must not be received as a lump-sum to be excluded from the definition of wages for FICA purposes.

However, in CSX, the Court of Federal Claims took a much broader view of the term. Between 1984 and 1990, CSX reduced its workforce significantly through layoffs, reductions in hours and pay rates, and permanent separations from employment. In each instance, the affected employee was entitled to a specific payment from the company.

The amount and duration of the payments were determined by either governing regulatory rulings or collective-bargaining agreements. Bi-weekly or monthly payments were paid to laid-off employees. Payments were also made to employees whose hours or pay rates were reduced. Finally, lump-sum payments or, alternatively, monthly payments extending over an agreed-on time period were paid to employees who ended their employment relationships with CSX as a result of the workforce reduction.

CSX paid the employer's share of FICA tax and withheld and remitted the employee's share. It then timely filed refund claims on its own behalf, as well as on the employees' behalf, arguing that the payments were "supplemental unemployment compensation benefits" not subject to FICA tax. The IRS rejected the claims, and litigation ensued.

CSX argued that supplemental unemployment compensation benefits are not subject to FICA tax, because they are not wages for Sec. 3121 purposes. Meanwhile, the Service argued that the nonwage characterization of such payments in Sec. 3402(o) does not extend to Sec. 3121 and therefore such benefits were wages for FICA purposes. The court agreed with CSX. It found that while the definition of wages for income tax purposes is not necessarily the same for FICA purposes, distinctions must be clearly delineated, and neither Congress nor the IRS has made such a distinction for supplemental unemployment compensation benefits.

The court then turned to each type of payment made by CSX, to determine whether it was, in fact, "supplemental unemployment compensation benefits," as defined in Sec. 3402(o). First, the court considered the bi-weekly or monthly payments made to employees who were laid off. The Service argued that the statute requires that an employee must be separated from employment for Sec. 3402(o) to apply, and that employees who are laid-off are not terminated. The court rejected this argument, finding:

"Separation from employment" within the meaning of section 3402(o) refers to a discontinuance in the performance of service by the employee for the employer rather than, as defendant would have it, a discontinuance of the employer-employee relationship in its entirety. Since a laid-off employee is not performing any service for the employer, such employee has undergone a "separation from employment" within the meaning of section 3402(o).

The court then considered payments made to employees whose hours or pay rates were reduced. It concluded that while these employees had a forced reduction in hours worked, they had not "separated" from CSX's employment and therefore payments made to them to make up for lost hours or lost wages were not supplemental unemployment compensation benefits under Sec. 3402(o).

Finally, the court considered the lump-sum and monthly payments, which extended over an agreed-on time period, made to employees who ended their employment relationships with CSX as a result of the workforce reduction. Pursuant to various negotiations with operating unions, CSX offered employees the option of terminating their employment relationship with the company in exchange for a separation payment. Such offers were made to all employees—those on layoff status, those on standby who might be laid off, and those holding full-time positions. CSX argued that despite the seemingly voluntary nature of each employee's receipt of a payment for such offer, a decision to leave CSX was actually involuntary, prompted by the ongoing threat of job loss due to the company's continuous downsizing. Meanwhile, the IRS argued that an employee's acceptance of a separation payment in exchange for termination was a purely voluntary action; thus, the payment was not a supplemental unemployment compensation benefit.

The court, in essence, "split the baby" with respect to these payments: It found that employees who elected separation payments in lieu of layoff benefits did not separate from employment voluntarily. Instead, they had already been separated and, by accepting the lump-sump payment, had elected "to resolve the uncertainty associated with a separation from employment of indefinite duration (i.e., the layoff) in favor of a permanent separation." Such payments made to laid-off employees, the court concluded, were therefore supplemental unemployment compensation payments. However, similar payments made to employees who elected to separate in lieu of remaining in their existing positions (including those whose hours had been reduced), but were still actively employed, could not be described as involuntarily separated. "For these employees, the decision to terminate the employment relationship is their own, not their employer's." Thus, the court held that the payments CSX made to those employees did not qualify as supplemental unemployment compensation benefits.

From Deborah J. Pflieger, J.D., LL.M., Senior Manager, Washington National Tax Office, Price- waterhouseCoopers LLP, Washington DC