SUB Payments Are Not FICA Wages


The District Court for the Western District of Michigan affirmed a bankruptcy court’s holding that severance payments by a bankrupt company to its laid-off employees were not subject to FICA tax. The court held that because IRC § 3402(o) subjects a supplemental unemployment benefit (SUB) payment to income tax withholding “as if it were a payment of wages,” absent any regulation requiring a different treatment, it is not a payment of wages for FICA tax purposes.


Section 3402(o)(2) defines SUBs as payments to an employee that are includible in the employee’s gross income and are made because of an involuntary separation from employment by a layoff, plant closing or similar condition. Such payments must be made pursuant to a plan to which the employer is a party.


Wages subject to the FICA tax include all cash and noncash remuneration paid to an employee for any service performed by an employee for an employer (section 3121) and any amount paid for the entire employer-employee relationship ( Social Security Board v. Nierotko, 327 U.S. 358 (1946)). Revenue Ruling 90-72, 1990-2 CB 211, excludes SUB payments as wages for FICA tax purposes if they are not received in a lump sum and if the payments are linked to state unemployment compensation. The Supreme Court, in Rowan Cos. v. U.S. (452 U.S. 247 (1981)), held that the definition of wages for FICA and FUTA purposes is the same as for income tax withholding purposes. After Rowan, Congress amended section 3121(a) (the “decoupling amendment”) to permit regulations that differentiate wages for income tax withholding purposes from wages for other tax purposes.


Quality Stores Inc. operated a chain of retail stores selling agricultural supplies. The company went into Chapter 11 bankruptcy and in 2001 terminated all its employees and closed its 374 stores and 12 distribution centers. Quality Stores withheld FICA taxes and paid the employer’s share of FICA taxes on the severance payments. The payments were not linked to state unemployment benefits. In September 2002, the company attempted to recover the FICA taxes by filing refund claims with the IRS totaling $1,000,125 plus interest. The bankruptcy court held the payments were not wages and therefore were not subject to FICA tax. The IRS, citing a contrary decision on similar facts by the Federal Circuit in CSX v. U.S. (518 F.3d 1328 (2008)), moved for a rehearing. (For more on CSX, see previous JofA Tax Matters coverage: “Courts on Board With CSX Case,” July 08, page 90; “FICA Holdings Overturned,” June 08, page 97; and “When Are Wages Not FICA Wages?” Dec. 06, page 80.) The bankruptcy court reheard the case but confirmed its earlier ruling. The IRS appealed the decision to the district court.


The IRS argued that the payments were subject to FICA taxes since they were made in connection with employment and could not be excluded from wages using Revenue Ruling 90-72. The court disagreed, stating that section 3402(o), governing income tax withholding, also controls the FICA tax treatment in this situation because the Rowan decision requires a consistent interpretation of “wages.” Also, the court noted that the Senate Committee report on the enactment of section 3402(o) in 1969 indicated that withholding had been deemed necessary because SUBs had not otherwise been considered wages subject to withholding but were taxable income to their recipients, causing underwithholding problems for taxpayers. Despite the existence of the decoupling amendment, no regulations differentiating wages for FICA and income tax withholding purposes had been issued. Furthermore, the court said, Revenue Ruling 90-72 did not override section 3402(o), since revenue rulings do not have the same effect as regulations. Therefore, in the court’s opinion, any payment that satisfies the definition of a supplemental unemployment compensation benefit in section 3402(o)(2) cannot be wages because, if it were, it would have been unnecessary for section 3402(o) to state that it should be treated as wages. The Federal Circuit in CSX had held that any payment satisfying the definition of SUB under section 3402(o)(2) was not automatically excluded as wages for FICA tax purposes. This court disagreed, stating that if “SUB payments were both wages and non-wages depending on the particular case, that distinction could easily have been made in the statute.”


In its opinion, the court described a spectrum with Social Security benefits at one extreme, wages at the other extreme, and a point in between where employee financial benefits should cease to be subject to the FICA tax. It believed that severance payments that serve the same purpose as Social Security are wage-replacement social benefits, not remuneration for employee services, and therefore should not be subject to the FICA tax.


  In re Quality Stores Inc. , docket no. 09-cv-44 (W.D. Mich., 2/23/10)


By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.


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