Rock, Paper, Scissors! (Resolution of Whether FICA Tax Applies to Severance Payments)

Stan Rose, Managing Director, Tax Practice
October 2013

There are many ways to resolve disputes.  For a short while I was proudly undefeated at “rock, paper, scissors” conflict resolutions involving my daughter and her friends.  I accomplished this by surprising them with the likeness of a fourth, secret, more powerful implement like a chainsaw, or nuclear missile.  Well, the IRS and some taxpayers figuratively have been playing their own game of rock, paper, scissors in court to resolve the question of whether or not FICA tax applies to severance payments, and the resulting ambiguity has left taxpayers in limbo regarding withholding payments.  However, this month the Supreme Court agreed to hear an appeal of one of the cases, and that should put an end to the game.  Taxpayers who have made severance payments (or will in the near future) should be aware of the dispute and take steps to preserve a potential refund of any such withholding.


Everyone is in agreement that severance pay is subject to income tax withholding.  However, the law is less clear regarding whether severance pay is subject to FICA tax withholding.  Not surprisingly, the IRS has always believed FICA applies, but the rules are sufficiently vague that over a decade ago, CSX Corporation initiated a lawsuit to recover such withheld taxes from the IRS.  The IRS initially lost that case in 2002, but they appealed and won a reversal in 2008 in the Federal Circuit Court of Appeals.  Then in 2010, a new contestant took a run at the IRS.  Quality Stores, Inc., sued to recover FICA taxes withheld from severance pay.  The court sided with the taxpayer, and the IRS predictably appealed.  However, late last year, the IRS lost that appeal in the Court of Appeals for the Sixth Circuit.  The IRS appealed again, to the U.S. Supreme Court, which agreed earlier this month to hear the case.  It likely will be decided by June of next year. 

Related curiosities

This mess is interesting, for a number of reasons:

  1. The Supreme Court often resolves cases involving disparate results between circuit courts, each of which handles cases arising in its own geographic location.  In this case, it will resolve a conflict between a lone circuit court and the completely separate Federal Circuit Court of Appeals, which handles cases based on subject matter.
  2. Supreme Court Justice Elena Kagan sat out the decision to accept this case, and apparently will sit out the case itself, due to an indirect connection to the case years ago.  This leaves 8 justices, and the possibility that a tie will leave the lower court’s decision intact (taxpayers win – at least in the Sixth Circuit).
  3. Throughout these court battles (spanning over a decade!), nothing has been stopping the IRS from writing new, clarifying rules that would clear this matter up proactively.  However, they have not done so.  Tax laws originate in Congress, with its laws being codified in the Internal Revenue Code.  However, Congress very often authorizes the IRS to write Treasury Regulations, which are given the force of law, to elaborate on and help implement the Code.  These rules appear to be eligible for such clarification, and if the IRS had done that, the court battles likely would have been unnecessary. 
  4. The IRS seemingly could still write such Regulations now, but recall it was their chess move that brought this mess to the Supreme Court, so they likely plan to wait for the outcome.  If they do not like the outcome, the IRS theoretically could neutralize the decision by drafting the Regulations then (the Supreme Court is merely interpreting existing law, and the IRS could simply re-write it).  While it seems implausible that they would do that, a lot hangs in the balance.  Protective claims (explained later) have been filed by many taxpayers, and the IRS has not processed those claims for several years, pending outcome of this dispute.  According to Forbes, nearly $130 million in refund claims have been suspended by the IRS in the Sixth Circuit alone, and many estimates of total tax refund claims in limbo nationwide exceed $1 billion!

What you can do?

Taxpayers making current severance payments could forgo FICA withholding based on the Quality Stores case, but there is a risk (especially for those outside of the Sixth Circuit) that penalties and interest could be assessed on the underpayment.  A better option seems to be reporting and paying the tax, but then filing a protective claim to request refund of the tax.  The IRS is not likely to process such claims anytime soon, but filing them locks in a taxpayer’s ability to obtain a refund if and when the Supreme Court rules for the taxpayers.  A protective claim is nothing more than a refund request that is dependent on future or possible events.  In this case, it would take the form of an amended payroll tax return: IRS Form 941-X, “Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund.”  IRS Publication 556 contains detailed instructions regarding additional information to include in such a filing for it to constitute a protective claim.  Generally, amended returns must be filed no later than 3 years from the date the original filing (Form 941 in this case) was made.


To our readers who have paid severance pay and withheld FICA taxes, I would recommend you consider filing protective refund claims, as explained above.  Be sure to do so before the 3-year Statute of Limitations expires.  To the 8 Supreme Court Justices participating in this case, I would point out that in the event of a 4-4 tie . . . do not overlook the soothing resolution potential of a good round of rock, paper, scissors.  It has served me well.

If you have any questions, please contact Stan Rose or your BNN tax advisor at 1-800-244-7444.

Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.

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