Severance pay planning in the wake of Quality Stores

Severance pay planning in the wake of Quality Stores

While this decision marks the end to a long road in the severance pay debate, Justice Kennedy s closing remark underscores the opportunity that continues to exist for SUB plans.

US Supreme Court rules in Quality Stores case lump-sum severance pay is subject to FICA On March 25, 2014, the US Supreme Court decided the Quality Stores case, ruling that severance payments that fail to satisfy the IRS criteria for supplemental unemployment benefits (SUBs) are subject to Social Security and Medicare (FICA). The 8 to 0 ruling by the justices is a decisive victory for the government, ending more than a decade of legal challenges triggered by CSX. Justice Kennedy, who rendered the opinion of the Court, explained that the severance payments issued by Quality Stores were made to employees terminated against their will, were varied based on job seniority and time served, and were not linked to the receipt of state unemployment benefits. Accordingly, Kennedy concluded that under FICA s broad definition, these severance payments constitute taxable wages. This [Quality Stores argument] is not consistent with the broad textual definitions of wages under FICA and income tax withholding nor is it consistent with this Court s holding [in Rowan] that administrative reasons justify treating severance payments as taxable for both FICA and income tax purposes. Justice Kennedy Broader definition of FICA wages prevails Quality Stores argued that the very title of IRC Section 3402(o), Extension of withholding to certain payments other than wages, supports the notion that Congress knew it was extending federal income tax withholding to payments other than wages. Relying on Rowan Cos. v. U.S., 452 U.S. 247 (1981), Quality Stores contended that the definitions of wages found in the FICA and federal income tax statutes should be interpreted consistently, leaving it to conclude that Congress intentionally characterized SUB payments as non-wages for purposes of both FICA and income tax withholding. Justice Kennedy countered that the major principle recognized in Rowan is that for simplicity of administration and consistency of statutory interpretation, the meaning of wages should be in general the same for FICA and income tax withholding. He went on to point out that Quality Stores would treat severance payments differently withhold for income tax and not withhold for FICA tax thereby causing differential treatment in the name of uniformity. This is not consistent with the broad textual definitions of wages under FICA and income tax withholding, Kennedy stated, nor is it consistent with this Court s holding [in Rowan] that administrative reasons justify treating severance payments as taxable for both FICA and income tax purposes. Kennedy further explained that to read Congress command to withhold severance payments as an implicit overruling of the broad definition of wages in FICA would disserve the statutory text and the congressional interest in administrative simplicity deemed controlling in Rowan. Severance pay planning in the wake of Quality Stores April 2014 1

US Supreme Court rules in Quality Stores case lump-sum severance pay is subject to FICA Continued Ernst & Young LLP insights While this decision marks the end to a long road in the severance pay debate, Justice Kennedy s closing remark underscores the opportunity that continues to exist for SUB plans. When properly structured against existing IRS guidelines, businesses planning a reduction in the workforce can continue to shave significant employment tax costs by taking advantage of the FICA exclusion that continues to apply. Expect denial of claims by IRS. Employers that filed protective FICA refund claims pursuant to CSX and Quality Stores should expect to receive letters from the IRS indicating their claims have been denied based on the Court s decision. The IRS has been disallowing these claims for taxpayers outside the Sixth Circuit. Opportunity to revisit SUB arrangements. Employers that routinely pay severance benefits or expect to pay such benefits in the future as a result of shutdowns, downsizing or seasonal employment may be able to realize substantial FICA savings by structuring these payments under a SUB plan that meets the requirements of Rev. Rul. 90-72. For more information concerning SUB plans, see page 3. No effect on SUB payments In its closing remarks, the Court noted that the IRS still provides that severance payments tied to the receipt of state unemployment benefits are exempt not only from income tax withholding but also from FICA taxation (Rev. Rul. 90-72, 1990 2) and that these revenue rulings are not at issue in this decision. Because the severance payments here (in Quality Stores) were not linked to state unemployment benefits, the Court does not reach the question whether the IRS current exemption is consistent with the broad definition of wages under FICA. FICA on severance 12 years at a glance 2002: Court of Federal Claims rules in favor of CSX that lump-sum severance pay is exempt from FICA [CSX Corp. v. United States, 52 Fed. Cl. 208 (Fed. Cl. 2002)] 2008: US Court of Appeals reverses the CSX decision, and CSX does not request Supreme Court review [CSX Corp. v. United States, 518 F. 3d 1328 (Fed. Cir. 2008)] 2010: Sixth Circuit Court rules in favor of Quality Stores based on CSX argument [United States v. Quality Stores, Inc. (In re Quality Stores Inc.), 693 F. 3d 605 (6th Cir. Mich 2012)] 2013: Government requests Supreme Court review of Quality Stores case, and Supreme Court agrees to hear the case [United States v. Quality Stores, Inc., 134 S. Ct. 49 (U.S. 2013)] 2014: Supreme Court decides Quality Stores case in favor of the government, saying that lump-sum severance pay is subject to FICA unless it meets the IRS criteria for supplemental unemployment benefits [United States v. Quality Stores, Inc., 572 U. S. (2014), U.S. LEXIS 2213 (U.S. March 25, 2014]) 2 Severance pay planning in the wake of Quality Stores April 2014

Severance planning can benefit businesses and employees affected by workforce reductions Employers that routinely pay severance benefits or expect to pay such benefits in the future as a result of shutdowns, downsizing or seasonal employment may be able to realize substantial Social Security and Medicare tax (FICA) savings for them and their employees by structuring these payments under a supplemental unemployment benefit (SUB) plan. (IRC 501(c)(17).) For example, assume an employer is forced to lay off 200 employees in connection with a plant shutdown and plans to pay $3,000 in severance benefits to each employee, or $600,000 in total. Normally, the employer would have to pay $45,900 in FICA taxes on these amounts [$600,000 * 7.65% = $45,900] for an effective cost of $645,900. In order to restructure these amounts as SUB benefits exempt from FICA/FUTA, the $3,000 in severance benefits could be paid to employees in 10 weekly installments of $300 (or other periodic amounts that qualify as SUB benefits) at an effective cost of only $600,000. Employees would save a comparable amount. What exactly is a SUB plan? The FICA/FUTA exemption for SUB stems from a series of revenue rulings, in particular Rev. Ruls. 56-249 and 90-72. The overriding theme of these rulings is that the SUB benefits must be designed to supplement state unemployment benefits according to the following requirements. Benefits are paid only to those employees who involuntarily separate from employment (e.g., plant shutdowns or reductions in force) and who meet prescribed conditions after termination of employment, such as registering for unemployment benefits with the state (Rev. Rul. 56-249). Benefits are payable only to those employees who satisfy the requirements for state unemployment benefits except if: The employee does not have sufficient wage credits under the state law. The employee has not satisfied the state-required waiting period. Or The employee has exhausted the state benefits. (Rev. Rul. 90-72.) Benefits are designed to supplement the state unemployment benefits. In Rev. Rul. 56-249, the benefits were integrated with state unemployment benefits such that the total payments (SUB and unemployment) to the employee were a specified percentage of the employee s pre-separation straight-time take-home pay. The benefits are paid periodically and not in a lump-sum distribution. (Rev. Rul. 90-72.) The benefits may either be paid through a trust or directly to employees through an unfunded program. (Rev. Rul. 60-330.) No employee has an interest in the SUB fund until the employee is qualified to receive benefits. (Rev. Rul. 56-249.) Ernst & Young LLP insights While there is planning involved in creating and administering SUB plans, they warrant investigation where the FICA tax savings outweigh the investment. Since long-term severance payout arrangements help businesses to stay connected to their former employees during transition periods, SUB plans are also worth consideration in situations where businesses believe their workforce needs will return in the future. Severance pay planning considerations Employers should keep in mind that there are several areas where severance planning can cut down on unnecessary costs and/ or facilitate a continuing connection with separated workers. Here are just a few. Consider supplemental unemployment benefit (SUB) plans Properly report severance and salary continuation payments to state employment agencies Properly exclude severance and similar payments from wages covered by state unemployment insurance where allowed by law Take advantage of state work share programs For more information concerning SUB arrangements and other severance planning opportunities, email Greg Carver or Kristie Lowery. Severance pay planning in the wake of Quality Stores April 2014 3

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