By Davis Yoffe, Senior Staff Writer

On October 1, 2013, as U.S. government shutdown, the Supreme Court not only stayed open, but granted certiorari for the new term.  One of the cases the Supreme Court will hear, styled on appeal as United States v. Quality Stores, Inc.[1], is of special interest to tax practitioners.  The issue in the case is “[w]hether severance payments made to employees whose employment was involuntarily terminated are taxable under Federal Insurance Contributions Act” (“FICA”).[2]  The case deals with the following situation: a business lays-off a worker and pays that worker a $10,000 severance payment pursuant to an existing union agreement.  If the payment is subject to FICA, the laid-off worker and the employer each contribute half of a $1,530 total tax liability.[3]  If the payment is not subject to FICA, the employer and employee keep the money.  Since many businesses lay-off numerous employees during times of economic trouble, such as a restructuring or a bankruptcy, a large number of workers are affected.  As an example of these situations, if a bankrupt business pays $10,000 in severance payments to a thousand workers, it must collect $1,530,000 in FICA taxes.  Considering the frequency of lay-offs, the tax amounts nationally quickly add-up to the billions.[4]

The background is relatively simple.  A person makes income, which is subject to Federal income tax.  Income includes numerous types of earnings, including rent payments, interest, dividends, and, the most common, wages.  When creating the Social Security and Medicare programs, Congress decided to fund these programs with taxes on “wages.”[5] To collect these taxes, Congress enacted section 3102 of the FICA withholding chapter, requiring employers to withhold FICA taxes from wages.[6]  This system is similar to income tax withholding, where Congress requires employers to withhold income taxes from wages under section 3402 of the income tax withholding chapter.[7]  Although the term “wage” is defined slightly differently in the FICA and income tax-withholding chapters; a 1980s Supreme Court, Rowan Co. v. United States,[8] states the two terms should be read similarly.

The tax controversy at the center of this case began in the 1950s, when several large companies agreed to make payments to supplement state unemployment benefits received by laid-off workers as part of agreements with trade unions.[9]  Companies developed these plans at the behest of unions to provide increased economic security to laid-off workers and, in return, management received some flexibility from unions during economic downturns. [10]  However, severance payments could not be legally characterized as wages, because under some state laws a person could not receive state unemployment if an employee was still being paid.[11]  The IRS accommodated and stated severance payments were not wages provided the payments meant several criteria, most importantly that the payment be received along with state unemployment.[12]  The severance payments which met the IRS criteria were termed as supplemental unemployment benefit (“IRS SUB”) payments.[13]

Through their respective chapters in the Internal Revenue Code (“Tax Code”), both FICA and income tax are withheld from wages.  Since the IRS SUB provision defined these severance payments as not wages, employers did not withhold income tax.  After the business paid the laid-off employees and the employees filled their yearly W-2s, they would then be hit with an income tax bill for the amount the employer normally withheld.[14]  Congress corrected this problem by passing section 3402(o) of the income tax withholding chapter, titled “[e]xtension of withholding to certain payments other than wages,” in 1969.[15]  Section 3402(o) states “any supplemental unemployment compensation benefit paid to an individual . . . shall be treated as if it were a payment of wages” and required the employer to withhold the employee’s income tax liability from the payment.[16]  Section 3402(o)(2)(A) goes on to define several criteria for a “supplemental unemployment benefit” (“3402(o) SUB”) payment, generally requiring the payment to made in the circumstances of a lay-off.[17]  However, section 3402(o)(2)(A) does not require the person receiving the payment to receive it in connection with unemployment compensation, a main requirement of IRS SUB.[18]  As many severance payments do not depend on the employee receiving state unemployment, they will meet 3402(o) and not the IRS SUB definition.[19]

The current circuit split developed from how two U.S. courts of appeals, the Federal Circuit and the Sixth Circuit, read section 3402(o) of the income tax withholding chapter in the context of FICA taxes.  The Federal Circuit case involved a program initiated by railway company CSX to pay unionized employees to leave the company.[20]  After paying the FICA taxes and suing the government for a refund, CSX unsuccessfully argued the payments meant the criteria of 3402(o) SUB payments and, therefore, were not wages and were only treated “as if” wages for income tax holding.  Thus, CSX argued that then the IRS exceeded its authority by declaring them wages for FICA purposes.[21]  CSX believed since Rowan Co.  required wages to mean the same in both income tax withholding and FICA, if the payments were not wages for purposes of income tax withholding, they could not taxable as wages under FICA.[22]

The Federal Circuit found for the government by reasoning the language of 3402(o) suggested it applied exclusively to the income tax withholding chapter of the Tax Code.  Additionally, the court interpreted the “as if” language in the statue as to not mean all payments were not wages, instead holding:  “to say that all payments falling within a particular category shall be treated as if they were a payment of wages does not dictate, as a matter of language or logic, that none of the payments within that category would otherwise be wages.”[23]  The court believed the payments at issue in the case were all part of 3402(o) SUB payments for purposes of the income tax withholding, but only the IRS SUB payments could be considered not wage payments for FICA.[24]  Essentially, the language of 3402(o) implied 3402(o) SUB payments were a wide category embracing two subcategories:  FICA taxable SUB payments; which were FICA wages, and the IRS SUB payments; which were not FICA wages under the revenue ruling, yet remained income.[25]  As the Federal Circuit read 3402(o) to not require all 3402(o) SUB payments be considered non-wages, it held Rowan Co. did not void the pertinent revenue ruling.[26]

The next case arose in the Sixth Circuit and dealt with the bankruptcy of the agriculture specialty retailer company, Quality Stores, which had become insolvent in 2001.  Quality Stores paid its managers and long-term employees to discourage them from searching for jobs while still employed by Quality Stores during the bankruptcy proceeding.[27]  However, compensation was not connected to receiving state unemployment.  Quality Stores paid the FICA taxes on these payments and then initiated a refund suit and won in the lower courts.  On appeal to the Sixth Circuit, Quality Stores again won its refund, causing the current circuit split.[28]

The Sixth Circuit agreed with taxpayer’s arguments, the same argument made by the taxpayer in CSX Corp., involving the “as if” wages of the statute and 3402(o)’s title.[29]  Congress, in committee reports, documented 3402(o) SUB payments are not subject to withholding for income tax because, as the legislative history states, “they do not constitute wages or remuneration for services.”[30]  The court invalidated the IRS revenue rulings as the plain language and legislative history both stated all 3402(o) SUB were not wages and Rowan Co. required the IRS not to interpret wage differently for each chapter.

In the petition for certiorari to the Supreme Court, the government’s argument consisted of three points.  Firstly, the term wages as defined in the Tax Code is intentionally broad and included SUB payments.[31]  The government stated the payments are “remunerations” and hence wages because they were calculated based upon the employees’ former positions, salaries, and length of employment.[32]  The payments were meant to keep current employees from job searching during bankruptcy.  Consequently the employees were providing a service, refraining from looking for new work while still employed, in return for the payments.[33]

Secondly, the IRS’s Revenue Ruling only exempted from FICA payments designed to supplement state unemployment.[34]  The government alleged that since Quality Stores’ severance payments do not take into consideration state unemployment, the payments do not meet the IRS’s criteria for exemption.[35]

Thirdly, the taxpayer made an erroneous interpretation of the 3402(o) in arguing all SUB payments were not subject to FICA taxes.  The government argued that the 3402(o)(1) language stating the payments “shall be treated as if it were a payment of wages,” applies only to the income tax withholding chapter and not the FICA tax chapter.[36]  As Congress meant 3402(o) to increase income tax withholding and wrote 3402(o) broadly to include both payments which meant the IRS SUB definition and those which the IRS considered wages.[37]  The government quoted the memorable metaphor from CSX Corp. to backup this logic: “[t]o say that for some purposes all men shall be treated as if they were six feet tall does not imply that no men are six feet tall.”[38]  The statute drafters did not concern themselves with the fact income tax withholding covered severance payments outside of the IRS SUB definition, because those payments were already subject to income tax withholding as wages and, thus, there would no practical effect to defining them as wages again.[39]

Quality Stores’ argument rested essentially on one point and followed the Sixth Circuit reasoning.  Namely, wages are defined the same way in both the FICA and income tax withholding chapters and Rowan Co. stated that both chapters are to be construed together.[40]  The FICA tax chapter’s statement that the SUB payments should be treated “as if” they were wages and the title of 3402(o) states the payments are “other than wages.”  Therefore, the payments are not wages for either chapter and are not subject to FICA taxes.[41]

The Supreme Court has not scheduled oral argument for United States v. Quality Stores, Inc.  The case is likely to be decided by eight justices because Justice Kagan took no part in the certiorari grant, suggesting she formerly worked on this case as solicitor general and will recuse herself.


[1] In re Quality Stores, Inc., 693 F.3d 605 (6th Cir. 2012), cert. granted, 81 U.S.L.W. 3680 (U.S. October 1, 2013) (No. 12-1404).

[2] Id.

[3] FICA outlines two separate flat taxes. The first supports the Social Security fund, a 12.4% tax on the first $113,700 in person’s wages, paid half by the employer and half by the employee. See 26 U.S.C. §§ 3101(a)-(b), 3111(a)-(b) (2006). An additional 2.9% on all wages, also half paid by the employer and half by the employee, supports the Medicare fund. See id. § 3102(a).

[4] See Laura Saunders, When Severance Pay Is Subject to Payroll Tax, Wall St. J., Oct. 26, 2012, available at (claiming refunds top two billion dollars).

[5] Anthony J. Badger, The New Deal: the Depression Years, 1933-1940, 231 (1989) (explaining the program was not to be funded from general revenue).

[6] See 26 U.S.C. § 3102 (imposing the duty of tax collection on employers).  Congress broadly defined wages for purpose of FICA as “all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash.” 26 U.S.C. § 3121(a).  Employment is defined as “any service, of whatever nature, performed . . . by an employee for the person employing them.” Id. § 3121(b).

[7] See id. § 3402 (stating all employers must withhold income tax liability from wages).  For income tax withholding, “wages” are defined as “all remuneration (other than fees paid to a public official) for services performed by an employee for his employer, including the cash value of remuneration paid in any medium other than cash.” Id. § 3401(a).

[8] 452 U.S. 247 (1981).

[9] See CSX Corp. v. United States, 518 F.3d 1328, 1334–1335 (Fed. Cir. 2008).

[10] See id.

[11] See id.

[12] See Rev. Rul. 56-249, 1956-1 C.B. 488 (stating amounts paid to individuals are not wages if they meet eight criteria, including a connection to state unemployment).  This is the first of several revenue rulings dealing with these payments, the most recent and the one at issue in Quality Stores is from 1990. See Rev. Rul. 90-72, 1990-2 C.B. 211 (requiring payment not be in lump and be linked to state unemployment).

[13] See Rev. Rul. 56-249, 1956-1 C.B. 488.

[14] See In re Quality Stores, 693 F.3d 605, 611 (6th Cir. 2012).

[15] See 26 U.S.C § 3402(o) (defining it as payments paid to an employee as part of plan, as the result of involuntary separation as part of a downsizing, to the extent it is included in gross income) (emphasis added).

[16] See id. § 3402(o) (emphasis added).

[17] See id. § 3402(o)(2)(A).  The requirements of 3402 are the following:  “[T]he term “supplemental unemployment compensation benefits” means amounts which are paid 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 such separation is 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.” See id.

[18] Compare id. (requiring the payment be received in the general circumstances of a lay-off) with Rev. Rul. 90-72, 1990-2 C.B. 211 (requiring the payment be tied with receiving unemployment).

[19] See, e.g., In re Quality Stores, 693 F.3d 605, 608 (6th Cir. 2012) (noting plan did not require receiving state unemployment); CSX Corp. v. United States, 518 F.3d 1328, 1331-333 (Fed. Cir. 2008) (same).

[20] CSX Corp. v. United States, 518 F.3d 1328, 1330-1333 (Fed. Cir. 2008).

[21] See id. at 1330-1331, 1337 (summarizing CSX’s main argument and, as a secondary argument, CSX argued the U.S. Senate report in passing 3402(o) stated “these benefits are not wages”).

[22] See id. at 1342.

[23] Id.

[24] See id. at 1340.

[25] See id. at 1342.

[26] See id.

[27] See In re Quality Stores, 693 F.3d 605, 608-609 (6th Cir. 2012)(explaining the company offered from, at most, eighteen months to, at least, one week of severance pay based on position and time spent at the company).

[28] See id. at 616.

[29] See id. at 611 (acknowledging 3402(o) is entitled “[e]xtension of withholding to certain payments other than wages” and 3402(o)(1) states a SUB payment “shall be treated as if it were a payment of wages”) (both emphasis in original).

[30] See id.

[31] Petition for a Writ of Certiorari at 9–12, United States v. Quality Stores, Inc, No. 12-1408,  (petition for cert. filed July 30, 2013).

[32] See id. at 9–11 (explaining the payments amounts were calculated using length of employment and position and acted as compensation for past service).

[33] See id. at 10.

[34] See id. at 14.

[35] See id.

[36] See id. (writing 3402(o)(1) states it only applies “[f]or the purpose of this [income tax withholding] chapter (and so much of chapter F as relates to this chapter”).

[37] See id. at 15–19 (“Congress’s decision to restrict the scope the rule set forth in Section 3402(o) to chapter 24 suggests that Congress did not intent to, or any implication that might be drawn from the rule, to be applied outside the context of income tax withholding.”).

[38] See id. at 19.

[39] See id. at 19–20.

[40] Brief in Opposition at 4–9, Quality Stores, Inc. (No. 12-1408).

[41] See id.

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