Are You Owed a Refund of FICA Paid on Severance Benefits?

A federal district court has opened the possibility of refunds for payments to terminated workers.

If you’ve been forced by economic conditions during the past two years to lay off workers and have given them various types of severance benefits, you probably paid Social Security and Medicare taxes (FICA) on those benefits. Now a federal district court has opened the possibility of refunds for prior FICA payments on certain payments to terminated workers.

The problem
FICA—both the employee share and employer share—is owed on payments that constitute “wages.” The definition of the term “wages” is the crux of the problem. During the recent Great Recession, many employers offered terminated workers various types of payments, including severance benefits, downsizing payments, and supplemental unemployment compensation (referred to as SUB-pay). The tax law specifically allows SUB-pay to be structured in such a way as to avoid the “wages” label and, thus, become exempt from FICA.

New development
A recent court decision has extended the SUB-pay exemption from FICA to traditional severance benefits. In Quality Stores, Inc., the court said severance benefits could be treated the same as supplemental unemployment compensation and would not be treated as wages if three conditions are met:

1. There is an employer plan under which payments are made;
2. Workers are involuntarily terminated (temporarily or on a permanent basis); and
3. There is a reduction in the work force, plant closing, or other similar condition that triggers the terminations.

What employers should do now
Companies that have laid off workers in the past several years and paid FICA on severance benefits should meet immediately with their tax advisors to discuss the next step.

Some things to do:

• Determine whether you have a “plan” within the meaning of the law. If you do not have one yet, consider structuring one for any future layoffs. It may pay to work with a benefits expert for this purpose; the FICA tax savings from a properly-structured plan could be substantial if this court decision holds up.
• Look for an appeal of the recent decision. This could take a year or more.
• Consider filing a “protective refund claim” now for FICA that has already been paid. The deadline for employees who were involuntarily terminated in 2006 is April 15, 2010. (It’s too late to claim a refund for FICA paid in years prior to 2006 because of the three-year statute of limitations.) Refund claims are made by filing Form 941X for each quarter in which FICA was paid on such severance payments. The employer can file for the employer share alone, or for the employer and employee share (provided the employee’s share is disbursed to the former employees).