IRS looks to US high court to resolve circuit split

By Robert W. Wood

If you are paying off a departing employee, you might be issuing a check on the employee's last day. If the employee's last day was a while back, you might cut a check in the hopes of avoiding a lawsuit. A claim against you may be brewing, may have been drafted, or may even have been filed.

Under these and other scenarios, you might reach for your checkbook, hoping to make the problem go away. Apart from how much money will be enough to resolve the claim, one big question will be whether and how to withhold taxes. Even if you decide to withhold, you must consider whether to withhold only income taxes or also Social Security taxes.

If you are the employer, your default rule should be that payments to employees or former employees are wages. Accordingly, you should generally withhold both income taxes and Social Security taxes. Plainly, that means you and the ex-employee will pay higher taxes than if you reported the payment on Form 1099-MISC as 'other income.'

Wage terminology clearly suggests withholding, but what do we mean by "wages"? The term is generally defined as all remuneration for services performed by an employee for an employer. It even includes the value of remuneration paid in something other than cash, subject only to limited exceptions. A similar (but not identical) set of rules applies to Social Security (FICA) withholding.

The most common type of payment to a terminated employee is severance pay. Back pay and severance pay are closely related but are not the same. Back pay is to compensate a person for pay he would have received up to the time of settlement or court award but for the employer's wrongful conduct. For example, back pay is awarded to an employee if he is illegally terminated by an employer, or to an applicant whom the employer chooses not to hire for illegal reasons.

Severance pay is taxable compensation income and is treated as wages. In fact, if you call something 'severance pay,' you have effectively made your withholding decision. Because severance pay is wages, you must withhold. But for income taxes alone?

Here's where it starts to get tricky. Some types of pay are wages for income tax purposes but not for employment tax purposes. For purposes of income-tax withholding and FICA, wages generally include all remuneration for employment. Severance pay is common, but is it remuneration for performing services?

Arguably no. Severance pay is gap pay to cover some period of time after the employee finishes rendering services. This distinction may not seem important, but significant tax dollars can turn on it. The law about withholding on severance pay is strangely muddled.

Severance can be paid for a variety of reasons. Providing severance may be company policy, may be required by state or federal law, or could be paid pursuant to an agreement between the company and the former employee. It could even be paid after years of bitter litigation.

Of course, severance pay is fully taxable for income tax purposes and is subject to income tax withholding. The question is whether it is also subject to payroll taxes like Social Security tax. You might assume so, and that's certainly what the IRS thinks.

But it turns out that federal courts have reached differing decisions. In 2002, the Court of Federal Claims considered severance pay made in downsizing programs implemented by CSX Corporation. The court ruled the severance pay was not wages under the FICA tax. See CSX Corp. v. United States, 52 Fed. Cl. 208 (Apr. 1, 2002). However, in 2008, the Federal Circuit Court of Appeals reversed and held that the severance pay was subject to FICA. See CSX Corp. v. United States, 518 F.3d 1328 (Mar. 6, 2008).

This was a clear holding, but it was not the last word. In 2012, the 6th Circuit reached the opposite result. Quality Stores, Inc. was in a Chapter 11 bankruptcy and made severance payments to terminated employees. In United States v. Quality Stores, Inc., 693 F.3d 605 (6th Cir. 2012), the 6th Circuit said severance pay was not wages.

Quality Stores had treated the payments as wages. The company withheld federal income and employment taxes and paid the IRS. Later, the company filed for a refund. The Bankruptcy Court concluded that the severance payments were not wages for FICA purposes. The district court affirmed and the 6th Circuit affirmed, too.

So is severance pay wages or not? It depends on who you believe. The IRS thinks the Federal Circuit was correct in CSX Corp. Taxpayers, on the other hand, are generally more persuaded by the 6th Circuit's ruling in Quality Stores.

The IRS has asked the Supreme Court to review the 6th Circuit's ruling. See United States v. Quality Stores, Inc., 693 F.3d 605 (6th Cir. 2012), petition for cert filed June 4 (No. 12-1408). In the meantime, the IRS has suspended action on tax refund claims totaling $127 million from approximately 800 taxpayers within the 6th Circuit. The 6th Circuit includes Kentucky, Michigan, Ohio and Tennessee.

More troubling, the IRS, convinced that it is right, has even been disallowing refund claims filed by employers outside the 6th Circuit. The IRS hopes the Supreme Court will agree to review the Quality Stores case and reverse it, making CSX Corp. the law of the land. It is too soon to say whether the Supreme Court will resolve this split in the circuits, or if it does, how the inconsistency will be resolved. If you are impacted by this and the dollars are significant, get some advice to protect your rights.

Robert W. Wood practices law with Wood LLP, in San Francisco (www.WoodLLP.com), and is the author of "Taxation of Damage Awards and Settlement Payments" (4th Ed. 2009 with 2012 Supplement), Qualified Settlement Funds and Section 468B (2009), and Legal Guide to Independent Contractor Status (5th Ed. 2010), all available at www.TaxInstitute.com. This discussion is not intended as legal advice, and cannot be relied upon for any purpose without the services of a qualified professional.

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