Federal Government Seeks Supreme Court Review of Quality Stores Decision Excluding Severance Payments from FICA

June 7, 2013

On May 31, 2013, the federal government, after requesting two extensions, filed its long-awaited petition for writ of certiorari seeking U.S. Supreme Court review of the decision by the U.S. Circuit Court of Appeals for the Sixth Circuit in United States v. Quality Stores, Inc., et al., 693 F.3d 605 (6th Cir. 2012), which held that certain severance payments received by employees were not subject to taxation under the Federal Insurance Contributions Act (FICA). The government sets forth three reasons why the Supreme Court should grant its petition: (1) the Sixth Circuit’s decision in Quality Stores is incorrect; (2) the decision in Quality Stores conflicts with decisions of the Supreme Court and other courts (it is in direct conflict with the decision of the U.S. Court of Appeals for the Federal Circuit in CSX Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008)); and (3) the issue raised is recurring and exceptionally important (it is pending in 11 cases and more than 2,400 administrative refund claims, and involves a total amount at stake of more than $1 billion). In its petition, the government understandably embraces the Federal Circuit’s holding and reasoning in CSX, and rejects those of the Sixth Circuit. Quality Stores has until July 1, 2013, to respond to the government’s petition.

In Quality Stores, the U.S. Court of Appeals for the Sixth Circuit faced the same issue regarding whether certain severance payments are subject to FICA taxation as the U.S. Court of Appeals for the Federal Circuit faced in CSX  and reached a different result. The courts agree that 26 U.S.C. § 3402(o) requires income tax withholding on supplemental unemployment compensation benefit (SUB) payments. It appears that they also agree that certain types of payments received by terminated employees do not constitute wages for income tax or FICA tax purposes. The courts differ, however, on whether Congress, in enacting § 3402(o), intended to exclude SUB payments from the definition of “wages” for income tax and FICA tax purposes. For a description of the facts in the case, see FICA Tax on Severance Payments Questioned.

The government does not argue that all SUB payments are subject to FICA taxation. In its petition, it briefly reviews the history of SUB payments (which originally were designed to supplement state unemployment compensation) and Internal Revenue Service rulings that address situations in which SUB payments do and do not constitute wages for FICA purposes (particularly Rev. Rul. 90-72, 1990-2 C.B. 211). Under applicable state law, employees could receive SUB payments, together with state unemployment compensation, as long as they did not constitute wages. If the SUB payments constituted wages, the employee would be precluded from receiving state unemployment compensation.

The Sixth Circuit decision is based on the belief that Congress intends the definition of “wages” to be the same for income tax purposes and FICA tax purposes with respect to SUB payments. According to the Sixth Circuit, Congress characterized SUB payments as “non-wages” and it enacted § 3402(o) simply to extend withholding to these “non-wage” payments to benefit taxpayers. Accordingly, if SUB payments are not “wages” but are treated as if they were “wages” for income tax withholding purposes, then SUB payments also are not “wages” under the nearly identical definition of that term for FICA tax purposes.

The government’s petition rejects this analysis and embraces the analysis of the Federal Circuit in the CSX case. The government contends that the Sixth Circuit’s reliance on § 3402(o) for the definition of “wages” is misplaced, and that the definition of “wages” under the FICA provisions is broad enough to include the termination payments made to the Quality Stores’ employees.

Before § 3402(o) was enacted, employees receiving termination payments that did not constitute wages for income tax or FICA tax purposes but were included in gross income found themselves subject to substantial tax obligations when they filed their income tax returns. The government asserts in its petition that § 3402(o) was enacted to withhold income tax from termination payments so that the employee would not be surprised by a substantial income tax obligation he may not be able to pay when he files his income tax return. Because all such payments are includable in gross income, it was not important for Congress to define SUB payments narrowly or to distinguish between them and other dismissal payments, according to the government. Therefore, the petition states § 3402(o) was enacted for the narrow purpose of ensuring that all payments received upon termination are subject to income tax withholding and not for the broader purpose of defining “wages” for income or FICA tax purposes.

The government contends that § 3402(o) is not applicable to the definition of “wages” for FICA tax purposes. Rather, the definition of “wages” for FICA tax purposes is found in the chapter of the Internal Revenue Code that deals with FICA (see 26 U.S.C. §§ 3121(a) and (b) for the definitions of “wages” and “employment,” respectively, for FICA tax purposes). FICA defines “wages” in relevant part as “all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash.” This broad definition easily encompasses the severance payments made by Quality Stores, according to the government.

The government’s petition provides the Supreme Court with the primary reasons why it should agree to review the case, but does not set forth every argument for overturning the Sixth Circuit’s decision. If the Court grants the petition and agrees to review the case, the government will then fully brief the Supreme Court on its position. The Supreme Court’s decision whether to hear the case likely will not be announced until this fall.

Employers that have made SUB payments on which they paid FICA taxes should consider filing a protective refund claim for open years to preserve their right to a refund in the event that the Supreme Court affirms the Sixth Circuit’s decision.

McGuireWoods will continue to monitor any developments in this area and keep you informed. For further information on the Quality Stores decision and its impact, please contact either of the authors of this article, Douglas W. Charnas and Jeffrey R. Capwell, or any other member of McGuireWoods’ federal tax controversy and litigation and employee benefits teams.