Payroll Taxes on Terminated Employees

mployers who withheld taxes on severance pay granted to certain terminated employees may be entitled to refunds. In CSX Corp., 52 Fed. Cl. 208 (2002), the Court of Federal Claims approved the refund of Railroad Retirement Tax Act (RRTA) taxes and Federal Insurance Contributions Act (FICA) taxes collected on amounts paid to certain employees under reduction-in-force programs. CPAs should read the decision to determine whether to file for refunds.

FACTS
From 1984 to 1990, CSX terminated about 20,000 employees through job layoffs, cuts in work hours and pay rates, and workers’ electing permanent separations from employment. Affected employees became entitled to a specific payment from the employer, as established either by government regulatory rulings or by superseding collective bargaining provisions. CSX paid its share of FICA and RRTA taxes and withheld and remitted the employees’ share.

TAXPAYER’S ARGUMENT
Later seeking a refund of those taxes, CSX argued that its payments to employees fell outside the definition of wages for FICA purposes and the definition of compensation for RRTA purposes. Rather, CSX contended that its payments fell within the definition of supplemental unemployment compensation benefits (SUCBs) as used in IRC section 3402(o). Such payments are not subject to FICA taxation or to income tax withholding.

COURT’S ANALYSIS
IRC section 3402(o)(2)(A) defines SUCBs as payments to an employee, pursuant to a plan to which the employer is a party, because of an employee’s involuntary separation from employment (whether or not temporary), resulting directly from a reduction in force, the discontinuance of a plant or operation or other similar conditions, but only to the extent such benefits are includible in the employee’s gross income.

For payments made to involuntarily terminated workers, the court concluded these laid-off employees were not performing any service for the employer. Thus, these payments qualified as SUCBs, not subject to payroll taxes, and eligible for a refund.

Payments made to employees on standby, who remained subject to recall on an as-needed basis and who received a guaranteed minimum compensation per pay period were subject to tax, because there was no separation from employment under IRC section 3402(o)(2); thus, these workers were not unemployed.

Finally, for payments made to employees who opted for early retirement, the court found that the voluntary surrender of employment rights for a cash payment represented the surrender of rights to future earnings for a present sum. Thus, these amounts were wages subject to payroll tax.

FUTURE ACTION
While CPAs can file refunds for eligible clients with laid-off employees for now, the IRS will probably suspend applications for such refunds, pending a decision on whether to appeal the CSX Corp. decision. For more information see the Tax Clinic, edited by Tom Ochsenschlager, in the February 2003 issue of The Tax Adviser.

—Lesli Laffie, editor
The Tax Adviser