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Severance Pay From Bankrupt Company Not Fica Wages, 6th Circuit Rules

Severance payments made to employees following their involuntary separation from their bankrupt employer are not subject to taxation under the Federal Insurance Contributions Act, a federal appeals court sitting in Michigan has ruled.

In re Quality Stores Inc. et al., No. 10-1563, 2012 WL 3871364 (6th Cir. Sept. 7, 2012).      The decision by a three-judge panel of the 6th U.S. Circuit Court of Appeals creates a split with the Federal Circuit, which made a contrary finding in 2008.

Lawyers for Pepper Hamilton LLP, the firm that represented Quality Stores Inc. and a number of former employees, said in a statement that the ruling “will provide strong support to taxpayers seeking refunds of FICA taxes paid in connection with the many workforce reductions that have occurred during the Great Recession.”

The now-defunct company became the subject of an involuntary Chapter 11 proceeding in 2001 in the U.S. Bankruptcy Court for the Western District of Michigan. At the time, it was the largest agricultural specialty retailer in the country, the 6th Circuit opinion said.

Quality Stores eventually folded operations, closing more than 300 stores.

The company subsequently made severance payments to all employees who had been involuntarily terminated. It reported the payments as wages on W-2 forms, withholding federal income tax, and begrudgingly withheld each employee’s FICA tax, which funds Social Security and Medicare.

When the Internal Revenue Service later refused a request to refund about $1 million in FICA taxes, the company and some former employees filed an adversary action in the Bankruptcy Court in 2005. They took the position that the payments were not wages but instead constituted supplemental unemployment benefits that are not taxable under FICA.

The Bankruptcy Court agreed in a 2008 decision, ordering a full refund. The court held that the payments made to involuntarily terminated employees constituted SUB payments that are not taxable as wages under FICA.

After the District Court affirmed that decision in 2010, the government appealed to the 6th Circuit.

The appeals court explained that U.S. Treasury regulations promulgated under FICA do not expressly address SUB payments, but the Supreme Court held in Coffy v. Republic Steel Corp., 447 U.S. 191 (1980), that supplemental unemployment benefits payments cannot by their nature be compensation for work performed.

The appeals court then interpreted the Internal Revenue Code to find that while Congress defines SUB payments as “wages” for purposes of federal income tax withholding, such payments have not been legislatively defined as “wages” for purposes of FICA taxation.

The panel acknowledged that the Federal Circuit adopted the government’s contrary position in CSX Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008).

The 6th Circuit rejected the Federal Circuit’s analysis of the issue using the IRS’s administrative definition of SUB payments rather than the congressional definition of wages in the Internal Revenue Code.

The appeals court’s docket does not yet reflect whether the government plans to take the case to the U.S. Supreme Court.

By Adam Hunt

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