Workplace Issues

Ruling Favors Employer Tax Refunds on Layoffs

To the benefit of taxpayers, an appeals court recently affirmed that FICA tax isn't owed on employee severance payments.
Thomas D. SykesSeptember 25, 2012

Editor’s Note: this article is one of three submissions CFO received from attorneys regarding an important court decision on FICA taxes for severance pay. While each reaches essentially the same conclusion, each also contains a unique discussion of the issues involved in the case. Read the other two articles here and here.

The question of whether FICA tax is owed on severance payments made during large-scale layoffs is alive and well — and employers should now re-focus on the issue. On Aug. 28, in the Quality Stores case, the U.S. Court of Appeals for the Sixth Circuit affirmed the decisions of two lower courts and held that FICA tax is not owed on those payments.

After the U.S. Court of Appeals for the Federal Circuit ruled that the tax is owed on a similar issue in March 2008 in the CSX Corp. case, however, it was understandable for corporate tax officials to conclude that the tax issue was dead. The Quality Stores ruling turns such a conclusion on its head.

Indeed, of the five federal trial and appellate courts that have looked at the issue, four have ruled in favor of taxpayers. “Real money” is very often at stake – millions or even tens of millions of dollars in employer-portion tax (accompanied by an equal amount of employee-portion tax). For example, an employer that paid $30,000 in severance to an employee making $60,000 per year would have paid $2,295 in employer-portion FICA tax respecting that employee; for a layoff of 5,000 employees with these compensation characteristics, the refund to the employer would come to over $11 million, plus interest.

Some employers, especially those seeking smaller refunds, will take a “wait and see” approach as the issue makes its way to a final resolution. The IRS is unlikely to capitulate: several billion dollars are reportedly at stake nationwide under refund claims that are already pending, and the IRS notched a victory in CSX Corp. A final resolution of the split in the appellate court decisions might take another five years or more. But a “wait and see” approach has definite risks for an employer because of the possibility that the refunds will be cut off by legislation from a Congress that is hunting for revenue, or by Treasury Regulations that are designed to flip over the card table during the middle of the game.

Prompt commencement of tax-refund litigation will often make sense for companies with larger refunds, especially for companies located within the Sixth Circuit (in Ohio, Michigan, Tennessee, and Kentucky). The employer’s tax officials need to review whether and when administrative claims that were previously filed, perhaps in an abrupt or unfocused fashion, need to be amended. Outside advice, provided by tax advisers familiar with employment taxes and, more importantly, with tax-refund litigation in the federal district courts against the U.S. Department of Justice, should be obtained so that the company understands the hazards, timetables, and costs of FICA-refund litigation. (This type of case cannot be brought in either the Court of Federal Claims or in the U.S. Tax Court.)

The outside adviser also needs to understand the extent to which settlement possibilities might emerge in dealings with the U.S. Department of Justice’s Tax Division, which will represent the government in court (not the IRS). The adviser needs to be familiar with the post-recovery rules that allow former employees to “piggyback” on the employer’s judgment or settlement. These, and other, “moving parts” take the next-steps question well beyond the typical, conventional advice to the effect that “claims for refund should be timely filed with the IRS,” into the rather more complicated, and hugely important, questions of whether and when suit in federal district court should be filed.

In sum, the recent decision in Quality Stores is very welcome news for employers that have downsized, and for their terminated employees. Employers that paid significant amounts of FICA tax on severance pay should: consider filing administrative claims so that their rights (and the rights of their former employees) to recover a FICA-tax refund are protected – and also consider whether previously filed claims should be promptly amended; immediately comply with all document-preservation requirements respecting refund claims that are filed; and promptly consult with a tax adviser who has an experience-based understanding of the myriad issues bearing upon whether and when tax-refund litigation in a federal district court, against the Department of Justice’s Tax Division, makes sense in the employer’s particular circumstances.

As to layoffs that are currently underway or that will take place in the future, employers should:

• Be attentive to the terms of the severance plan that is created.

• Collect and pay FICA tax (and income-tax withholding) on the severance payments, unless and until there is a formal IRS reversal of position.

• Consider filing claims for a tax refund if the facts come within the rationale of the Quality Stores opinion.

• Insure that documents relevant to the claim are preserved.

Thomas D. Sykes, a former U.S. Department of Justice tax litigator, is a shareholder in the Chicago office of Greenberg Traurig, LLP. The views in this article are Mr. Sykes’s, and not necessarily those of Greenberg Traurig.