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COURT RULING EXPANDS FICA EXEMPTION FOR CERTAIN SEPARATION PAYMENTS

In a recent case in the Court of Federal Claims (CSX Corporation v. United States), the Court overturned the IRS's longstanding position that most separation payments made pursuant to a RIF did not qualify as "supplemental unemployment compensation benefits" ("SUBs") that are exempt from FICA.

Howard J. Rubin (hrubin@dglaw.com)
Raphael S. Lee (rlee@dglaw.com)


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The Court of Federal Claims recently ruled that certain separation payments paid pursuant to a reduction in force ("RIF") are exempt from FICA taxes. Under this ruling, employers who previously paid FICA tax on certain separation payments may wish to apply for a tax refund. In a recent case in the Court of Federal Claims (CSX Corporation v. United States), the Court overturned the IRS's longstanding position that most separation payments made pursuant to a RIF did not qualify as "supplemental unemployment compensation benefits" ("SUBs") that are exempt from FICA. By doing so, the court held that separation payments for involuntary separations resulting from a RIF were exempt from FICA. The ruling applies to terminations due to reductions in force only, and not to individual terminations for poor performance or cause.

The tax code categorizes SUBs as "payments other than wages," and are therefore not subject to the FICA wage tax. SUBs are defined as follows:


amounts 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.

This definition is in the chapter of the tax code regarding income tax withholdings, but has been interpreted by the courts and by IRS revenue rulings to define a non-wage category for purposes of FICA as well.
The IRS had previously maintained that separation payments were not SUBs unless their amounts were directly linked to unemployment benefits. Under its interpretation of the tax code, as set forth in a Revenue Ruling, a separation payment would not be exempt from FICA unless it was "linked to the receipt of state unemployment compensation and . . . not [] received in a lump sum." Presumably this was because the IRS did not deem other types of payments to be a form of supplemental unemployment compensation, though the revenue ruling does not explain any rationale for its decision.

The Court of Federal Claims rejected the IRS's position in CSX Corporation. The court, noting that there was no explanation given for the IRS's position regarding SUBs, applied the plain language of the statute to determine whether separation payments constituted SUBs. Under CSX Corporation, to qualify as a SUB and be exempt from FICA, a payment has to be (1) made pursuant to a plan to which the employee is a party; (2) because of an employee's involuntary separation from employment; and (3) resulting directly from a reduction in force or similar conditions.

In CSX Corporation, the employer offered two types of separation payments pursuant to a RIF. The first provided a lump sum payment to terminate employment (and relinquish all rights and benefits) for employees who were on layoff status and who chose the separation payment in lieu of layoff benefits. The court held that this first category of payments constituted a SUB, since it was a plan payment due to involuntary separation (the employees were already laid off) resulting from a RIF. Although those payment agreements acknowledged that the employee's resignation was "voluntary," the court found that the employment had already been involuntarily severed, and so the payments were SUBs.

The second category of payments was made to employees on stand-by or full-time status to leave the employer in lieu of continued employment, whether that employment was to be in the same or in a different position. This category was found not to be wages because they did not result from an "involuntary" separation. The court found that the decision to terminate the employment relationship was "their own" rather than their employers, even though the agreement may have been accepted because of the possibility of a layoff or forced transfer.

In light of the CSX decision, employers have a basis for not applying FICA taxes to qualifying RIF separation payments in the future, and may have an opportunity to apply for a refund for qualifying past separation payments. However, since it still can be assumed that the IRS will oppose this position and force this matter into court, the employer must weigh the cost of a refund proceeding (including potential IRS audit risk for the years in question) against its benefits.


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