Past Layoffs Could Provide Tax Refund

A recent court ruling suggests that companies may be able to recover FICA taxes linked to severance pay. But to take full advantage of the first refund year, they'll have to file before April 15.

Layoffs have been a grim feature of the economy over the past few years. Last month alone, such big names as Sallie Mae, BP Solar, and Siemens joined smaller companies like furniture maker Knolls, electrical-wiring manufacturer Pass & Seymour/Legrand, and medical-equipment supplier Rom-Hill in reducing head count.

Now there may be some good news amid the misery: Uncle Sam may owe companies, and their laid-off employees, a tax refund related to severance payments. The refund comes courtesy of a February ruling in which a Michigan district court upheld a bankruptcy court decision involving defunct farm- and garden-equipment supplier Quality Stores Inc. In essence, the court said FICA (Federal Insurance Contribution Act) payroll taxes should not apply to severance payments for laid-off workers because the payouts do not meet the tax code’s definition of wages. If the decision is upheld, companies and employees who already paid their taxes may be eligible to recover the cash.

But companies will have to act fast if they want to recover qualified payments made in 2006, because the statute of limitations for that year is up on April 15. Companies have more breathing room after that, as the deadlines for filing refund claims for subsequent years are a year or more away. For example, for the 2007 tax year, refund claims must be filed by April 15, 2011.

Under FICA, companies pay taxes on wages at a rate of 7.65%. That rate comprises two portions: 6.2% for old age, survivors, and disability insurance (OASDI) and 1.45% for Medicare. Similarly, employees have 7.65% of their wages withheld by their companies and sent to the government. (The OASDI rate applies to wages up to $106,800 for 2010, but there is no cap on the wage amount to which the Medicare tax rate applies.)

The reason companies are able to claim the refund is somewhat complicated. It starts with the Internal Revenue Service taking the position that severance payments are considered wages and therefore subject to FICA, as well as Medicare taxes. In 2002 that position was challenged by railroad company CSX, and a federal district court found in favor of CSX. But the IRS eventually won an appeals decision that allowed the government to deny the refund claims.

That seems straightforward enough — except that prior to the IRS winning its appellate-level victory over CSX, Quality Stores filed its own case against the IRS in bankruptcy court, and won. The victory came in part because the failing company based its argument on the CSX decision, which at the time had not yet been overturned, explains Bill Smith, a tax attorney and managing partner at CBiz MHM, an accounting and finance consultancy. Even after the CSX decision had been overturned, the bankruptcy court stood by its ruling that payments made to laid-off workers are not considered wages for FICA tax purposes. What’s more, the bankruptcy court’s ruling was affirmed by a federal district court in February, dealing another blow to the IRS.

It’s unclear what the IRS will do with refund claims filed for the 2006 tax year. The agency could file an appeal, and if it wins, it could deny the refunds at that time. Or, the IRS could deny claims now, based on its CSX win. The only thing that’s clear “is that we don’t expect the IRS to send a check,” says Smith. Regardless of which tack the agency takes, Smith suggests that companies may want to file a protective refund claim before next week to guard against losing the opportunity to recover 2006 FICA taxes.

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