Preserve tax refunds on severance ? Business Management Daily ...

If your company has struggled in recent years, it may have been forced to lay off workers. Along with the pink slips, you might have handed out severance packages. Of course, your company deposited with the Feds all the requisite federal employment taxes on the severance payments.

Strategy: File a ?protective claim? to preserve your potential right to a federal employment tax refund for open tax years.

According to a new case decided by the 6th Circuit, qualifying severance payments aren?t subject to federal employment taxes, so you could be in line for a big refund. But the IRS hasn?t thrown in the towel on this issue yet and probably won?t unless ordered to by the Supreme Court.

And no wonder?the stakes are high. In the new case, the IRS had to refund more than $1 million in em??ploy??ment tax deposits. (U.S. v. Qual??ity Stores, Inc., CA-6, 9/7/12)

Here?s the whole story: Generally, wages that are subject to federal income tax withholding are also treated as wages for federal employment tax purposes. However, the new 6th Circuit decision says severance payments that meet the description of Sup??ple??men??tal Un??em??ploy??ment Com??pen??sa??tion Benefits (SUB) are ex??cluded from the definition of ?wages? for federal employment tax purposes. To qualify as SUB, a ?payment must be:

• Made to an employee
• Pursuant to your company?s plan
• Due to an employee?s involuntary separation from employment
• As a direct result of a reduction in force, discontinuance of a plant or operation, or similar conditions
• Included in the employee?s gross income (i.e., reported as income on Form W-2).

Because severance payments are clearly wages for federal income tax purposes, the IRS has steadfastly maintained that severance payments to terminated workers are subject to federal employment taxes. Traditionally, the courts have agreed with the IRS, but the new 6th Circuit decision throws a monkey wrench into the works.

Facts of the case: A large retail chain, Quality Stores, ran into financial difficulties and had to close hundreds of stores and distribution centers and terminate employment of thousands of workers. Discharged employees received severance in amounts based in part on their date of termination.

Initially, Quality Stores reported the severance payments as wages on employees? W-2s, withheld income taxes and federal employment taxes on those amounts, and paid its share of the employment taxes. Then it filed refund claims for overpaid employment taxes totaling more than $1 million. ?

A Michigan district court ruled these severance payments should not be characterized as wages for employment tax purposes. Reason: It said that the payments were SUB payments.

Now the 6th Circuit Court of Appeals has sided with the lower court. It found that Con??gress has expressly provided that any payment that meets the statutory definition of a SUB payment is treated as if it were a payment of wages, but only for federal income tax withholding purposes. Therefore, SUB payments are not wages for federal employment tax purposes.

Note that this new decision conflicts with a 2008 decision by the Federal Court of Claims. (CSX Corp. v. U.S., CA-FC, 3/6/08) The IRS is mulling its options, and this issue is probably headed to the U.S. Supreme Court for a final resolution.

Until then, play it safe: Withhold all the taxes and file a protective claim for a federal employment taxes refund. Contact your tax pro about how to do that. In addition, ask your tax pro how to file refund claims for federal employment taxes paid on SUB payments made in earlier years and the deadlines for filing those refund claims.

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