Some severance not subject to employment taxes.

Over the past decade, many businesses have had to downsize their workforce to stay competitive. Severance payments to workers generally are considered wages subject to withholding for

* Income taxes under IRC sections 3401 and 3402.

* Federal Insurance Contributions Act (FICA) under IRC section 3121.

* Federal Unemployment Tax Act (FUTA) under IRC section 3306.

* Railroad Retirement Tax Act (RRTA) under IRC section 3231.

Revenue ruling 90-72 excludes certain supplemental unemployment compensation benefits (SUCBs) from the definition of wages for FICA, FUTA and RRTA purposes. However, section 3402(o) extends income tax withholding to certain payments other than wages, such as SUCBs.

CSX Corp., the parent of a consolidated group of railroad companies, was forced to downsize its workforce from 1984 to 1990 due to a decline in rail transportation and increased competition. The number of CSX's railroad-related employees decreased to 34,000 from 54,000 during that period. The management workforce declined by 33%, the union workforce by 39%. CSX accomplished the reduction through a combination of job layoffs, reductions in the number of hours of work and rates of pay and permanent separations from employment.

Affected employees received payments as follows:

* Those laid off received biweekly or monthly payments.

* Those with reduced hours or pay rates received payments of at least a guaranteed minimum amount.

* Those who agreed to terminate their employment with CSX received either lump-sum payments or monthly payments for an agreed-upon period of time.

In accordance with RRTA and FICA, the company paid the employer's share of employment taxes and withheld and remitted the employees' share of those payments. It then filed refund claims for the employment taxes, maintaining those payments were not wages or compensation but, rather, SUCBs and as such not subject to tax. The IRS disallowed the claims. CSX took the case to the U.S. Court of Federal Claims.

Result. For the taxpayer. The court concluded that some of the payments were not wages subject to FICA or RRTA. Specifically, the payments that met the definition of SUCBs under section 3402(o)--paid to an employee because of his or her involuntary separation from employment resulting from a reduction in workforce--were not considered wages subject to employment taxes. In reaching this conclusion the court interpreted the U.S. Supreme Court decision in Rowan Cos. and the subsequent "decoupling amendment" to section 3121 to mean the definition of "wages" is consistent for FICA and income tax withholding purposes unless the IRS promulgates regulations to identify differences between the two. No such regulations have been issued. The IRS argued that if Congress had intended SUCBs to be exempt from FICA, it specifically would have excluded such payments in section 3121. The court disagreed since SUCBs were not wages in the first place.

The IRS also argued that the payments did not qualify as SUCBs because they did not meet the conditions in revenue ruling 56-249 and related rulings. Revenue ruling 56-249 dealt with whether benefits from an employer-funded trust were subject to FICA and income tax withholding. The trust's purpose was to supplement state unemployment benefits for employees laid off in a workforce reduction. Payments were based on the size of the trust, the amount of state unemployment benefits, the duration of the layoff, the time worked before layoff and other conditions. On the basis of those eligibility conditions, the revenue ruling concluded the payments were income but not wages subject to employment taxes and withholding. In the CSX case, the court declined to consider these conditions since the revenue ruling did not explain how the conditions supported the ruling's conclusion that the benefits were not subject to FICA. In addition, the conditions were not incorporated into later amendments to section 3402.

Based on its interpretation of the issues discussed above, the court held

* The biweekly or monthly payments to laid-off employees were SUCBs, not subject to FICA or RRTA.

* Payments to those workers with reduced hours or pay rates were subject to FICA and RRTA because they were "underemployed" but not separated from employment.

* Separation payments employees elected to receive voluntarily rather than stay in their current positions or accept reduced rates or hours were subject to FICA and RRTA.

This decision is significant for any taxpayers that have paid employment taxes on severance payments similar to the CSX workforce reduction payments. Those taxpayers should consider filing claims for refund of FICA taxes they paid as well as withheld and remitted on behalf of employees. The IRS is likely to appeal this decision to the Federal Circuit Court of Appeals.

* CSX Corp. v. United States, 89 AFTR2d 2002-1935.

Prepared by Karyn Bybee Friske, CPA, PhD, associate professor of accounting and Darlene Pulliam Smith, CPA, PhD, professor of accounting, both at the T. Boone Pickens College of Business, West Texas A&M University, Canyon.