Source: https://www.cadwalader.com/resources/clients-friends-memos/the-sixth-circuit-rules-in-united-states-v-quality-stores-inc
Timestamp: 2019-04-25 01:16:34+00:00

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Downsizing is a fact of life in the recent U.S. economy. Over the past several decades, employers have involuntarily terminated large numbers of employees and made severance payments totaling hundreds of millions of dollars to the departing workers. The Internal Revenue Service (the “IRS”) and courts agree that severance payments are income to the employees and subject to federal income tax. However, the employment tax statutes, FICA for non-railroad employees and RRTA for railroad employees, impose employer and employee taxation on only one subset of “income”: “wages” under FICA and “compensation” under RRTA,1 both of which are generally defined as remuneration received for services rendered. Courts have generally held that normal severance payments are “wages,” sometimes citing for support the legislative history to the Social Security Amendments of 1949 defining dismissal payments (any payment paid by an employer to an employee on account of an employee’s involuntary separation from the service of the employer) as wages for FICA. But what about severance payments paid to employees as a direct result of a work force reduction? In 1990 the IRS ruled that lump sum severance payments paid to employees who were involuntarily separated as a direct result of a work force reduction were wages for FICA and compensation for RRTA because they were indistinguishable from dismissal payments.2 Earlier this month, the Sixth Circuit disagreed, holding that work force reduction severance payments are not dismissal payments, but non-wage supplemental unemployment compensation benefits (“SUB payments”) that are not subject to FICA tax. The Sixth Circuit reached its decision after careful examination of a half century of IRS pronouncements, the FICA and federal income tax withholding statutes and legislative history, and relevant Supreme Court precedent. In reaching its decision, the Sixth Circuit declined to follow a contrary 2008 Federal Circuit decision that similar work force reduction severance payments were taxable wages under FICA under controlling IRS guidance.
The Sixth Circuit case is United States v. Quality Stores, Inc., No. 10-1563, 2012 WL 3871364, (6th Cir. Sept. 7, 2012) (“Quality Stores”), in which a three-judge panel unanimously affirmed the lower court’s decision that the severance payments at issue were not subject to FICA tax.3 The United States has not yet announced whether it will seek a panel or en banc rehearing, or U.S. Supreme Court review of the Sixth Circuit’s decision by filing a petition for a writ of certiorari.4 In order to be timely, a petition for a rehearing must be filed within 45 days after entry of judgment, unless a court order shortens or extends the time. In order to be timely, a petition for a writ of certiorari must be filed within 90 days after entry of the judgment, unless the government files a petition for rehearing by the Sixth Circuit, in which case the 90 day period would run from the date of the denial of the petition for rehearing or, if rehearing is granted, from the date of the subsequent entry of judgment.
Quality Stores was the largest agricultural implement retailer in the United States, serving farmers, hobby gardeners, skilled trade persons, and do-it-yourself customers. Prior to and pursuant to a bankruptcy reorganization, Quality Stores closed all its 374 stores, all its distribution centers, and terminated the employment of all its employees. Quality Stores made severance payments to those employees whose employment was involuntarily terminated. The government and Quality Stores agreed that all the severance payments resulted directly from a reduction in force or the discontinuance of a plant or operation.
Severance payments were paid under both a Pre-Petition Severance Plan and a Post-Petition Severance Plan. Payments made under neither plan were tied to the receipt of state unemployment benefits, nor were they attributable to the provision of any particular services. Payments under the Pre-Petition Plan were paid periodically under the normal payroll schedule. Payments under the Post-Petition Plan were paid in a lump sum because the affiliated companies were liquidating and it was not feasible to pay the amounts over time. Neither Plan required employees to be unemployed to receive the payments. The Plans covered both management and hourly employees. Under the Pre-Petition Plan, salaried employees received an average of 11.4 weeks of severance pay and hourly employees an average of 4.2 weeks of severance pay. Under the Post-Petition Plan salaried employees received 5.2 weeks of severance pay, while hourly employees received 3.1 weeks of severance pay.
On the basis of the Federal Circuit’s CSX decision, the government filed a motion for reconsideration of Quality Stores with the bankruptcy court.13 Upon reconsideration, the bankruptcy court ratified its previous decision.14 The government then appealed to the federal district court for the Western District of Michigan which, despite the contrary Federal Circuit decision, affirmed the bankruptcy court’s decision, holding that the “treated as if it were a payment of wages” language in section 3402(o) clearly meant that SUB payments were not wages but were merely being treated as wages to allow federal income tax withholding, a statutory meaning that the court thought was confirmed by legislative history stating that a special withholding rule was necessary precisely because the payments “do not constitute wages or remuneration for services” and would not be subject to withholding without the enactment of a special legislative rule. The Quality Stores district court also held that since SUB payments are defined as non-wage payments for purposes of federal income tax withholding, they are also non-wage payments for purposes of FICA under the Supreme Court’s decision in Rowan,15 and that the 1983 Social Security Amendments did not change this result. Regarding the Federal Circuit’s statutory interpretation that section 3402(o) included both wage and non-wage SUB, the district court stated: “With all due respect to the Federal Circuit, [that interpretation] strains logic and effectively ignores clear statutory language.” Accordingly, the court affirmed the bankruptcy court’s decision for refund. The United States appealed to the Sixth Circuit. Oral argument was held in October 2011. The Sixth Circuit affirmed the 2010 district court decision in a decision that was decided and filed on September 7, 2012.
The Sixth Circuit began its analysis with a reminder that while the term “wages” is defined in the FICA statute, neither that statute nor Treasury regulations expressly include, or exclude, SUB payments within, or from, the definition of wages.16 However, the Congressional definition of wages in the federal income tax withholding statute is nearly identical to the Congressional definition of wages in FICA,17 the court also reminded, and the federal income withholding statute does contain a definition of a SUB payment. The questions for the court became whether (1) the severance payments at issue satisfied the congressional definition of SUB payments contained in section 3402(o) of the Code, (2) Congress regarded these payments as wages or non-wage payments for purposes of federal income tax withholding, and (3) the federal income tax withholding answer to the second question also applies to FICA.
Second, the court held that SUB payments were not wage payments under the income tax withholding statute. Focusing on the statutory words in section 3402(o)(1) that a SUB payment “shall be treated as if it were a payment of wages by an employer to an employee for a payroll period,” the court concluded that “the necessary implication arising from this phrase is that Congress did not consider SUB payments to be ‘wages’, but allowed their treatment as wages to facilitate federal income tax withholding for taxpayers.” To the extent that any argument could be made that these operative words might be ambiguous, the court held the title of the statute21 and the statute’s legislative history22 removed any potential ambiguity.
The Sixth Circuit thus rejected the IRS’s and the Federal Circuit’s contrary conclusions.
Based on the Sixth Circuit’s decision in Quality Stores, taxpayers in that circuit should strongly consider filing refund claims for payments similar to those described in Quality Stores. All other taxpayers should also consider filing refund claims, at least on a protective basis, for similar types of payments for all open years and, where appropriate under all their particular circumstances, consider entering into agreements with the IRS to extend the statute of limitations to permit the preparation and filing of such refund claims. While the IRS will probably not acquiesce to the Sixth Circuit’s Quality Stores decision, and probably will deny all claims for refund filed outside the Sixth Circuit (and perhaps in the Sixth Circuit as well), a timely filed refund claim is a requirement for later filing a refund suit either in the United States Court of Federal Claims or the appropriate federal district court. It is important for taxpayers to preserve their rights to file administrative refund claims and refund suits, especially if the government seeks Supreme Court review, the Supreme Court decides to hear the appeal, and the Supreme Court affirms the Sixth Circuit’s decision in Quality Stores.
1 FICA is shorthand for the Federal Insurance Contributions Act. RRTA is shorthand for the Railroad Retirement Tax Act. Both impose employment tax on the employer and the employee. The principal difference between the FICA and RRTA regimes are in the rates of tax. For 2012, the FICA employer tax rate is 6.2% on wages up to $110,100, and the FICA employee tax rate is 4.2% on the same wage base (the 2% reduction in the FICA employee tax rate will expire on January 1, 2013, unless Congress chooses to extend it). In addition, FICA employers and employees are subject to a 1.45% Medicare tax on all earnings without cap. For 2012, these same FICA tax rates and caps are incorporated in the RRTA regime as Tier l taxation. RRTA also incorporates the 1.45% Medicare tax on both employers and employees. In addition, RRTA has a Tier II tax. The 2012 RRTA Tier ll tax on employees is 3.9% on $81,900 of wages, and the 2012 RRTA Tier ll tax on employers is 12.1% on $81,800 of wages. As seen from these different rates, RRTA taxation is more onerous on railroad employees than FICA taxation on non-railroad employees, and RRTA taxation is significantly more onerous on railroad employers than FICA taxation on non-railroad employers.
2 Rev. Rul. 90-72, 1990-2 C.B. 211.
3 In 2008, a U.S. bankruptcy court ordered the United States to make refund of the employer and employee FICA taxes that the employer had paid (employer tax) and withheld and remitted (employee tax) to the IRS. Quality Stores, Inc. v. United States (In re Quality Stores, Inc.), 383 B.R. 67 (Bankr. W.D. Mich. 2008). The bankruptcy court decision was appealed to federal district court, which affirmed the bankruptcy court decision in 2010. United States v. Quality Stores, Inc. (In re Quality Stores, Inc.), 424 B.R. 237 (W.D. Mich. 2010). Although the Sixth Circuit affirmed the decision of the federal district court, the court noted that on an appeal from a district court judgment in a case that originated in bankruptcy court, the Sixth Circuit reviews the bankruptcy court’s decision directly, without giving any deference to the district court’s decision.
4 On September 14, 2012, IRS deputy division counsel and deputy associate chief counsel (Tax-Exempt and Government Entities) told the American Bar Association Section of Taxation meeting in Boston that the government was still deciding whether to seek a Sixth Circuit rehearing or seek certiorari to the Supreme Court. Tax Notes Today, September 17, 2012.
5 While returns and refund claims with respect to federal income taxes are filed on a consolidated basis, employment tax returns and refund claims are filed on a separate company basis. A Quality Stores holding company and ten affiliates were the debtors. A total of 15 refund claims were filed by four of the affiliates.
6 Quality Stores, Inc. v. United States (In re Quality Stores, Inc.), 383 B.R. 67 (Bankr. W.D. Mich. 2008).
7 Congress wanted to treat SUB payments as wages (without defining them as wages) so that federal income tax would be withheld during the year without also subjecting the payments to FICA tax, which would have been the case if Congress had defined SUB payments as wages.
8 CSX was represented by David W. Feeney and Burton Spivak of Cadwalader, and the late Stephen N. Shulman.
9 CSX Corp. v. United States, 518 F. 3d 1328 (Fed. Cir. 2008). David W. Feeney, Burton Spivak and the late Stephen N. Shulman also represented CSX on its appeal to the Federal Circuit. The Quality Stores bankruptcy case was decided on February 21, 2008. The Federal Circuit decided the CSX case on March 6, 2008. The Federal Circuit also held that the payments at issue in the CSX case were “compensation” for RRTA to the extent that the payments were paid to railroad employees.
10 Rev. Rul. 56-249, 1956-1 C.B. 488.
11 Rev. Rul. 77-347, 1977-2 C.B. 362.
12 Rev. Rul. 90-72, 1990-2 C.B. 211. This ruling revoked that portion of Revenue Ruling 77-347 that had ruled to the contrary. The 1990 revenue ruling did not affect the payments at issue in the CSX case because they were made before the effective date of the ruling.
13 The motion was filed on May 16, 2008.
14 The ratification order was dated August 29, 2008.
15 Rowan Cos. v. United States, 452 U. S. 247 (1981).
16 The definition of wages in FICA is a two-part definition. First “wages” is defined as “all remuneration for employment.” I.R.C. §3121(a). Second, employment” is defined as “any service, of whatever nature, performed . . . by an employer for the person employing him.” I.R.C. 3121(b).
17 The withholding statute defines “wages” as “all remuneration . . . for services performed by an employee for his employer … including the cash value of all remuneration (including benefits) paid in any medium other than cash.” I.R.C. § 3401(a).
18 I.R.C. §3402(o)(2)(A). The statutory definition is repeated in the corresponding Treasury Regulation, §31.3401(a)-1(b)(14)(ii).
19 The court buttressed its argument with Code section 501(c)(17), enacted in 1960, which provided an income-tax exemption for SUB trusts. The court noted that the definition of a SUB payment contained in this statute “closely mirrors” the definition in section 3402(o). The court also pointed out that Congress was aware that employers had developed a variety of SUB plans, and Congress wished to facilitate SUB plans because they provided worthwhile benefits. Furthermore, while acknowledging that the definition of “service performed by an employee “is broad, the court also relied on the Supreme Court’s “particular instruction” in Coffy that “SUB pay falls outside the broad statutory meaning of services performed . . . because, by definition, an employee is not eligible for SUB pay until service to the employer has ended and such benefits provide compensation for the lost job.” Coffy v. Republic Steel Corp., 447 U.S. 191 (1980).
20 Rev. Rul. 90-72, 1990-2 C.C. 211.
23 The court also pointed out that, to date, Treasury has not published any regulations authorized by the decoupling amendment. Other subsections of the withholding statute allow for withholding with respect to certain payments for annuities and sick pay listed in §3402(o)(1)(B) & (C). The government also argued that it would have been unnecessary for Congress to exclude annuity payments and sick pay from the FICA definition of “wages” if they were already considered non-wages for FICA purposes. The court rejected this argument for the same reason that the lower court in Quality Stores and the trial court in the CSX case rejected the argument: SUB payments were non-wage payments to start with, and therefore did not require a specific FICA exclusion.
25 The IRS intended its 1990 revenue ruling to restore the distinction that it believed a prior IRS revenue ruling had blurred between SUB pay (a narrow exclusion from wages) and dismissal pay, a broader concept that included severance pay and had long been subject to FICA taxation. The prior ruling was Rev. Rul. 77-347, 1977-2 C.B. 362.

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