Quality Stores had paid severance to terminated employees in connection with an involuntary Chapter 11 bankruptcy, and had withheld income and FICA taxes from those payments. Quality Stores then sought to recover the FICA taxes by, among other things, filing refund claims with the Internal Revenue Service (the "IRS"). Quality Stores argued that the severance payments were not "wages" that would be subject to FICA taxation, but rather were more properly classified as "supplemental unemployment compensation benefits," or "SUBs," because they were "wage-replacement social benefits."

SUBs, as defined in Internal Revenue Code ("Code") Section 3402(o)(2), are payments that are (i) paid to an employee, (ii) pursuant to a plan of the employer, (iii) because of the employee's involuntary separation from employment (whether or not the separation is temporary), (iv) due to a reduction in force, the discontinuance of a plant or operation, or other similar conditions and (v) includible in the employee's gross income. The IRS had argued that, as set forth in Revenue Ruling 90-72, in order for severance payments to be classified as SUBs (and therefore excludable from FICA tax), the payments must be linked to the receipt of state unemployment compensation and must not be received in a lump sum. The District Court disagreed with the IRS (as had the Bankruptcy Court) and ordered the IRS to refund the FICA taxes paid by Quality Stores.

The District Court's decision in Quality Stores is similar to a 2002 decision of the US Court of Federal Claims in CSX Corp. v. United States. In that case, the Court held that severance payments similar in nature to those made by Quality Stores were SUBs and therefore exempt from FICA taxes. The US Court of Appeals for the Federal Circuit, however, reversed the lower court's decision in 2008, holding instead that the severance payments were subject to FICA taxation because they were remuneration for services and thus "wages" subject to FICA taxation. However, in the period between the lower court's decision and the Court of Appeals' reversal, many employers had filed refund claims for FICA taxes previously paid with respect to severance payments, on the chance that the IRS would be required to treat severance payments as SUBs.

Although the IRS is likely to appeal the Quality Stores decision, and we believe that it is probable that the Sixth Circuit will agree with the US Court of Appeals for the Federal Circuit's decision in CSX Corp. that such severance payments are subject to FICA taxation, employers who have made severance payments that would meet the Code's definition of SUBs (irrespective of the IRS's argument that the payments must also be linked to the receipt of state unemployment compensation and not be received in a lump sum in order to be SUBs) should consider filing a refund claim for FICA taxes paid with respect to those severance payments, in the event the Quality Stores decision is affirmed. Since refund claims must be filed by April 15 of the third year following the year in which the employer paid the FICA tax, employers who wish to file a protective FICA tax refund claim for the 2006 calendar year must do so by April 15, 2010.

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