March 7, 2013

FICA Tax Refunds May Be Available on Some Severance Pay

Employers that have paid severance pay to employees in connection with reductions in force in recent years may be eligible for refunds of their Federal Insurance Contribution Act (“FICA”) payments for Social Security and Medicare taxes. To cover the earliest reductions in force for which such refunds may be available, employers should consider filing protective tax refund claims by April 15, 2013.

Whether employers are entitled to such refunds has been and continues to be a matter of dispute. Until there is a Supreme Court decision or a change in the position of the Internal Revenue Service (“IRS”), the entitlement to a refund will remain uncertain. However, a court decision in the fall of 2012 by the Sixth Circuit Court of Appeals, United States v. Quality Stores, Inc., highlights the potential refund opportunity.


Under the Internal Revenue Code, “wages” are subject to income tax withholdings and FICA taxes. However, a payment of “supplemental unemployment benefits” (a “SUB payment”) is subject to an exception from the definition of “wages” for FICA purposes. In a 1990 revenue ruling, the IRS determined that to qualify as a SUB payment, a severance payment would need to be linked to receipt of state unemployment insurance benefits, including the termination of payments in the event of new employment. Thus, according to the IRS, lump-sum severance pay or periodic payments of severance pay that are not linked to state unemployment insurance cannot qualify for the exception from FICA taxes and related withholdings. Employer severance pay plans do not typically link severance payments to state unemployment insurance payments.

The Quality Stores Decision

Quality Stores, Inc. operated a series of warehouse retail stores that sold agricultural equipment and supplies. In 2001, it declared bankruptcy, closed all of its stores and terminated all of its employees. The company designed two severance plans for its terminated employees. Some employees received lump-sum severance payments while others received periodic payments. The severance payments were not tied to state unemployment benefits. Therefore, the position of the IRS was that the payments under these severance plans were not exempt from FICA.

Quality Stores disputed that determination. The Sixth Circuit Court of Appeals held that the severance payments were not subject to FICA tax withholdings. The court concluded that a payment would qualify as a SUB payment and would be exempt from FICA if it is:

1) an amount paid to an employee

2) pursuant to an employer’s plan

3) because of an employee’s involuntary separation from employment, whether temporary or permanent

4) resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions and

5) included in the employee’s gross income.

The court held specifically that the severance payment need not be linked to state unemployment insurance to be exempt from FICA tax withholdings.

The Circuit Split

In 2008, the United States Court of Appeals for the Federal Circuit rejected an argument similar to the one made by Quality Stores, concluding that payments in connection with a reduction in force were subject to FICA tax. The Sixth Circuit’s Quality Stores decision created a split between federal circuit courts.

The IRS estimates that the total dollar amount at issue nationwide as a result of the Quality Stores decision is over $1 billion. Given the circuit split, the amount at issue, and the desirability of a uniform national rule, the IRS may well seek U.S. Supreme Court review. The IRS has until April 4, 2013 to file a petition for a writ of certiorari with the Supreme Court.

Employer Action Required

In light of Quality Stores, employers that have paid severance pay in connection with a reduction in force or similar circumstances and pursuant to a plan within the last several years should consider filing a protective refund claim. A protective claim preserves the employer’s right to receive a FICA tax refund, should the Supreme Court agree to review the Quality Stores decision and decide in favor of taxpayers. The protective claim generally must be filed within three years of the tax return date for the year in which the severance payments were made. For example, if FICA taxes were paid in 2009, a protective claim must be filed by April 15, 2013.

Inside the Sixth Circuit, the IRS has suspended all action on all reduction in force and similar refund claims pending final resolution of the Quality Stores case. Outside the Sixth Circuit, the IRS has been denying such refund claims and likely will continue to do so. Employers that receive a Notice of Claim Denial have two years from the date of that notice to file a refund suit in U.S. District Court or in the U.S. Court of Federal Claims. If the issue remains unresolved when that two-year deadline approaches, an employer that receives a Notice of Claim denial could consider filing Form 907, Agreement to Extend the Time to Bring Suit, in order to preserve the right to receive a FICA tax refund either in court or through the IRS Appeals Office.


Employers that have made severance payments in connection with reductions in force or similar circumstances pursuant to a plan since 2009 should consider filing protective tax refund claims by April 15, 2013. A protective claim will preserve an employer’s right to receive a FICA tax refund should the Quality Stores case finally be resolved in favor of the taxpayer. However, until the FICA tax issue has been resolved, employers – at least those located outside of the Sixth Circuit – generally should continue to withhold and remit the employee and employer portions of FICA tax on severance payments that are not linked to state unemployment insurance.