Involuntary severance benefits not subject to FICA tax.

Severance pay is generally considered compensation for services rendered and as such, wages subject to income tax and FICA tax withholding. The IRS has clearly stated this position in Regs. Sec. 31.3401(a)-1 (b)(4), which states, "any payments made by an employer to an employee on account of dismissal, that is, involuntary separation from the service of the employer, constitute wages regardless of whether the employer is legally bound by contract, statute, or otherwise to make such payments," as well as in Rev. Rul. 75-44, for FICA taxes.

However, in CSX Corp., 4/1/02, the Court of Federal Claims concluded that certain severance payments were not subject to FICA taxes. While the definition of wages in Sec. 3121 for FICA tax purposes usually mirrors the definition of wages for income tax withholding purposes in Sec. 3401, only under Sec. 3402(o) are "supplemental unemployment compensation benefits" subject to income tax withholding; no similar specific exception exists for Sec. 3121 purposes. Therefore, the court concluded, "supplemental unemployment compensation benefits" are not subject to FICA taxes.

Note: The CSX decision occurred just two weeks prior to the close of the statute of limitations for all four quarters of 1998 employment tax returns, which caused taxpayers to file a flurry of protective claims with the IRS by April 15, 2002. Whether employers will do the work necessary to perfect those claims will depend on the future of the CSX decision.

Under Sec. 3402(o), an employer must withhold income taxes from "supplemental unemployment compensation benefits" Such benefits are:

[A]mounts 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.

Traditionally, the Service has sought to restrict the types of payments considered supplemental unemployment compensation benefits. In Rev. Rul. 90-72, it ruled that such benefits must be linked to the receipt of state unemployment compensation and must not be received as a lump-sum to be excluded from the definition of wages for FICA purposes.

However, in CSX, the Court of Federal Claims took a much broader view of the term. Between 1984 and 1990, CSX reduced its workforce significantly through layoffs, reductions in hours and pay rates, and permanent separations from employment. In each instance, the affected employee was entitled to a specific payment from the company.

The amount and duration of the payments were determined by either governing regulatory rulings or collective-bargaining agreements. Bi-weekly or monthly payments were paid to laid-off employees. Payments were also made to employees whose hours or pay rates were reduced. Finally, lump-sum payments or, alternatively, monthly payments extending over an agreed-on time period were paid to employees who ended their employment relationships with CSX as a result of the workforce reduction.

CSX paid the employer's share of FICA tax and withheld and remitted the employee's share. It then timely filed refund claims on its own behalf, as well as on the employees' behalf, arguing that the payments were "supplemental unemployment compensation benefits" not subject to FICA tax. The IRS rejected the claims, and litigation ensued.

CSX argued that supplemental unemployment compensation benefits are not subject to FICA tax, because they are not wages for Sec. 3121 purposes. Meanwhile, the Service argued that the nonwage characterization of such payments in Sec. 3402(o) does not extend to Sec. 3121 and therefore such benefits were wages for FICA purposes. The court agreed with CSX. It found that while the definition of wages for income tax purposes is not necessarily the same for FICA purposes, distinctions must be clearly delineated, and neither Congress nor the INS has made such a distinction for supplemental unemployment compensation benefits.

The court then turned to each type of payment made by CSX, to deter mine whether it was, in fact, "supplemental unemployment compensation benefits," as defined in Sec. 3402(o). First, the court considered the biweekly or monthly payments made to employees who were laid off. The Service argued that the statute requires that an employee must be separated from employment for Sec. 3402(o) to apply, and that employees who are laid-off are not terminated. The court rejected this argument, finding:

"Separation from employment" within the meaning of section 3402(o) refers to a discontinuance in the performance of service by the employee for the employer rather than, as defendant would have it, a discontinuance of the employer-employee relationship in its entirety. Since a laid-off employee is not performing any service for the employer, such employee has undergone a "separation from employment" within the meaning of section 3402(o).

The court then considered payments made to employees whose hours or pay rates were reduced. It concluded that while these employees had a forced reduction in hours worked, they had not "separated" from CSX's employment and therefore payments made to them to make up for lost hours or lost wages were not supplemental unemployment compensation benefits under Sec. 3402(o).

Finally, the court considered the lump-sum and monthly payments, which extended over an agreed-on time period, made to employees who ended their employment relationships with CSX as a result of the workforce reduction. Pursuant to various negotiations with operating unions, CSX offered employees the option of terminating their employment relationship with the company in exchange for a separation payment. Such offers were made to all employees--those on layoff status, those on standby who might be laid off, and those holding full-time positions. CSX argued that despite the seemingly voluntary nature of each employee's receipt of a payment for such offer, a decision to leave CSX was actually involuntary, prompted by the ongoing threat of job loss due to the company's continuous downsizing. Meanwhile, the IRS argued that an employee's acceptance of a separation payment in exchange for termination was a purely voluntary action; thus, the payment was not a supplemental unemployment compensation benefit.

The court, in essence, "split the baby" with respect to these payments: It found that employees who elected separation payments in lieu of layoff benefits did not separate from employment voluntarily. Instead, they had already been separated and, by accepting the lump-sump payment, had elected "to resolve the uncertainty associated with a separation from employment of indefinite duration (i.e., the layoff) in favor of a permanent separation." Such payments made to laid-off employees, the court concluded, were therefore supplemental unemployment compensation payments. However, similar payments made to employees who elected to separate in lieu of remaining in their existing positions (including those whose hours had been reduced), but were still actively employed, could not be described as involuntarily separated. "For these employees, the decision to terminate the employment relationship is their own, not their employer's." Thus, the court held that the payments CSX made to those employees did not qualify as supplemental unemployment compensation benefits.

FROM DEBORAH J. PFLIEGER, J.D., LL.M., SENIOR MANAGER, WASHINGTON NATIONAL TAX OFFICE, PRICEWATERHOUSECOOPERS LLP, WASHINGTON DC

Editor:
Mark H. Ely, J.D., CPA
Partner
Washington National Tax
KPMG LLP
Washington, DC