New Case May Create Refund Opportunity for Severance Pay

Was your company forced to lay off employees during the recent economic downturn? You may be in line for a refund for some of the taxes paid on severance amounts but depending on when the payments were made, you may have to act fast. A recent U.S. District Court case ruled that these amounts do not constitute wages for FICA payroll tax purposes. Here are the details of the new case and what they might mean for your company.

COURT RULES THAT SEVERANCE PAYMENTS ARE NOT WAGES

A recent U.S. District Court case may provide a unique tax-saving opportunity for employers who have been forced to lay off workers during the recent economic downturn. In a surprising move, the Court said that severance payments made to the workers do not constitute “wages” for payroll tax purposes. Thus, the company was able to collect a refund of more than $1 million!

In the wake of this new case, you can file a protective refund claim for open tax years if your company previously paid the full amount of payroll taxes on severance payments. But you may have to act fast to file a claim for the 2006 tax year.

Let’s start with some basics. As a general rule, “wages” that are subject to income tax withholding are also treated as wages for employment tax purposes. For 2010, an employee must pay a 6.2 percent Social Security tax on the first $106,800 of wages and a 1.45 percent Medicare tax on all wages. The employer must also pay its corresponding share of these employment taxes.

Since severance payments are clearly wages for federal income tax purposes, the IRS has steadfastly maintained that any severance package paid to a terminated worker is subject to employment taxes. Traditionally, the courts have gone along with this viewpoint. But a new ruling from a district court in Michigan upsets the apple cart.

Facts of the new case: Quality Stores, a large retail chain specializing in agricultural products, closed more than 60 stores and nine distribution centers when it encountered financial difficulties. It also terminated approximately 75 employees at its corporate offices. In 2001, an involuntary Chapter 11 bankruptcy petition was filed against the retail outfit. Quality Stores then closed its remaining 311 stores and distribution centers. Finally, it discharged all the employees who were still left on the payroll.

The terminated employees received severance payments based in part on their date of termination. Initially, Quality Stores reported the severance payments as wages on employees’ W-2 forms, withheld the appropriate amount of income taxes and employment taxes, and paid its share of the employment taxes. However, after a Bankruptcy Court ruling, it filed refund claims in 2002 for overpaid employment taxes totaling $1,000,125, plus interest, on the severance payments.

Favorable result: The District Court ruled the severance payments should not be characterized as wages for employment tax purposes. Its theory: The payments effectively represent wage-replacement social benefits. Because severance payments are intended to provide support to workers who have lost the ability to earn wages, the Court said that it didn’t make sense to impose employment taxes on these benefits (U.S. v. Quality Stores, Inc., D.C.-W. Michigan, 2/23/10)

The government argued that the payments to employees were made in connection with employment, and payroll taxes were due.

In its opinion, the District Court referred to a landmark Supreme Court case (Rowan Companies, Inc., 452 US 247, 1981). The Supreme Court determined in the Rowan case that Congress intended a uniform definition of “wages” for income tax and employment tax purposes. Subsequently, Congress passed a “decoupling rule” separating the imposition of employment taxes from the treatment of income taxes in existing regulations. Absent any further regulations, other IRS rulings do not have authority to impose employment taxes in this situation.

The District Court ruled that the severance payments are wages for income tax purposes, but not for FICA tax purposes. Undoubtedly, we have not heard the last word on this issue. The IRS is expected to appeal the Quality Stores decision.

Practical approach: Based on the pro-taxpayer outcome in this new case, employers should carefully consider whether severance benefits are subject to employment taxes. And following the lead of Quality Stores, a company and its employees may file refund claims for previously paid taxes. Your tax adviser can provide the necessary guidance in this area. In light of this case, your company may initiate a protective refund claim for tax years dating back to 2006 since taxpayers have a three year statute of limitations to follow. So for the 2006 tax year, a taxpayer would have to file a claim by April 15, 2010. More information from the IRS »

The statute of limitations generally expires three years from the due date of the tax return or the date filed, whichever is later. It does not include extensions.

The IRS is unlikely to pay out refunds until an appeals case is completed, if the tax agency decides to go that route, but you must file a protective claim on time in order to secure the right to a refund.

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“This case presents a straightforward, but legally confounding question: whether severance payments qualify as wages subject to FICA taxation … The few courts that have addressed this issue, or variations of it, have reached directly opposing outcomes.”

– U.S. District Court in the Quality Stores Inc. case

BUSINESS WISDOM FOR TODAY’S ECONOMY

Hiring Your Child this Summer?

Payments for the services of children under age 18 who work for their parent’s business are not subject to Social Security and Medicare taxes if the entity is a:

Sole proprietorship or

Partnership in which each partner is a parent of the child.

In addition, payments for the services of a child under age 21 who works for his or her parent in a trade or business are not subject to FUTA tax.

On the other hand, the wages for the services of a child are subject to Social Security, Medicare, and FUTA taxes if he or she works for:

A corporation, even if it is controlled by the child’s parent.

A partnership, even if the child’s parent is a partner, unless each partner is a parent of the child.

Income tax must be withheld from a child’s pay, regardless of age or entity.