Court Reverses Broad-Based FICA Exclusion for Severance Payments

By Ira B. Mirsky, J.D., LL.M., Ernst & Young LLP, Washington, DC

Editor: John L. Miller, CPA.

Over the past six years, many employers have been filing protective claims for refunds of Social Security and Medicare (FICA) taxes in connection with severance payments while awaiting resolution of CSX Corp., 52 Fed. Cl. 208 (2002). The trial court’s decision in CSX allowed FICA refund claims based on a fairly broad interpretation of a statutory exclusion for “supplemental unemployment compensation benefits” from the definition of “wages,” for employment tax purposes, under Sec. 3402(o).

The reason an employment tax issue potentially affecting thousands of employers has languished for so long may be attributed largely to the curious procedural history of the trial court decision. The April 1, 2002, Court of Federal Claims decision was issued as a temporary order, which limited the government’s ability to appeal until all outstanding issues were resolved. This preliminary decision was followed in October 2003 and June 2006 by two supplemental decisions addressing various issues. During this interval, with the government’s ability to appeal procedurally limited, the IRS notified employers that it was suspending FICA refund claims.

Court of Federal Claims Decision

The Court of Federal Claims decision in CSX involved separation payments made to three different groups of employees in connection with a reduction in workforce plan. The three groups of employees consisted of:

  • Employees who were put into layoff status as part of the plan and who were paid monthly layoff benefits during the time they were in this status. The amounts of the benefits paid were based on each employee’s average monthly compensation, and the amount of time they were paid was based on the length of each employee’s service with CSX.
  • Employees whose full-time positions were eliminated but who were retained for part-time work as needed by CSX. These employees were paid a certain minimum compensation per period adjusted for work actually performed.
  • Nonmanagerial employees who elected to terminate their employment with CSX in exchange for a separation payment instead of receiving layoff benefits.

The trial court held that based on the text and legislative history of Sec. 3402(o), supplemental unemployment benefits were excluded from wages for employment tax purposes. The trial court further held that Sec. 3402(o)(2)(A) imposed only two requirements in order for severance payments to qualify as supplemental unemployment compensation benefits. Specifically, severance needs to be paid:

1. Under a plan to which the employer is a party, and

2. Because of an involuntary separation from employment resulting directly from a reduction in workforce.

Thus, according to the trial court, separation payments meeting these two requirements for supplemental unemployment compensation benefits are not considered wages for FICA tax purposes.

Criteria for Exclusion

The trial court found that the payments made to all three categories of employees met the first requirement. However, it ruled that only those employees in the first group described above met the second required element of an involuntary separation from employment and that payments to these employees were supplemental unemployment compensation benefits and therefore were not subject to FICA taxes. The trial court found that the employees in the other two categories had not involuntarily separated from employment. As a result, it held that although the payments to these employees were made under essentially identical terms as the payments made to the employees in the first group, they did not qualify as supplemental unemployment compensation benefits and therefore should be treated as wages subject to FICA taxes.

In reaching its determination that the severance payments to the first category of employees were not wages for employment tax purposes, the trial court disregarded the additional requirements to qualify for treatment as supplemental unemployment compensation benefits that the IRS argued should apply under Rev. Rul. 56-249 (partially revoked by Rev. Rul. 90-72).

Rev. Rul. 56-249 imposes the additional requirements that separation payments must be specifically designed to supplement state unemployment benefits and, under the terms of the plan providing for these separation payments, the employee must be unemployed and must meet the requirements for eligibility to receive state unemployment benefits in order to qualify for the exclusion from FICA taxes. The IRS asserted that the revenue ruling established the standards for the qualification of payments as supplemental unemployment benefits under Sec. 3402(o). The trial court declined to extend the application of Rev. Rul. 56-249 to all determinations regarding supplemental unemployment benefits, arguing that “Rev. Rul. 56-249 can have no persuasive force” (52 FedCl at 217) because it failed to analyze why these additional conditions were a prerequisite to excluding the payments from the definition of wages for federal income and FICA tax purposes. The trial court further noted that Congress could have included these additional criteria in Sec. 3402(o) when it enacted the provision but chose not to.

FICA Tax Planning Following the CSX Decision

Following the trial court’s decision in CSX, many practitioners advised employers of the potential FICA tax refund opportunity for employment taxes paid in connection with severance payments made under a reduction in the employer’s workforce to employees that had been involuntarily terminated.

Employer’s Obligation to File a Claim for Refund of Employee FICA Taxes

Generally, an employer may not simply file a refund claim for only the employer’s share of overpaid FICA taxes. Rather, while an employer may file a protective claim for refund of both the employer’s and the employee’s share of FICA taxes, Regs. Sec. 31.6402(a)-2 requires an employer to solicit consents and certifications from employees in order for the employer to perfect the claim and thus be eligible to receive a refund of the entire amount of its claimed employer’s share as well as the employee’s share for those employees who have so consented. (Note that 45 days is a rough benchmark to wait for employee consents and certifications based on IRS experience in dealing with FICA refund claims in various areas.)

The employer’s obligation under the regulations to pursue the employees’ claim for overpaid FICA taxes may potentially raise tricky human resources and logistical issues (including the cost of correspondence) because it requires communicating with terminated employees. In addition, some employment law counsel have raised the concern that once an employer has solicited consents from these former employees, the employer has obligated itself to follow through on the claims for FICA refunds on behalf of the employees who have consented even if future court decisions or IRS interpretative guidance threatens the viability of these claims for refund. Based on these considerations, some employers have decided not to pursue FICA refund claims in connection with substantial employee severance payments.

In the overwhelming majority of cases, employers have filed “bare bones” protective refund claims in order to protect the statute of limitation to potentially make FICA refund claims once the CSX litigation was resolved. These protective claims enable employers to delay the decision of whether to incur the considerable expense and legal obligations associated with perfecting a FICA refund claim on behalf of employees.

Appellate Decision

In March 2008, the Federal Circuit reversed the decision of the Court of Federal Claims that the qualification of payments as supplemental unemployment benefits under Sec. 3402 required the payments to be treated as nonwages for FICA tax purposes (CSX Corp., No. 2007-5003 (Fed. Cir. 3/6/08)). The appeals court held that the category of separation payments eligible for exemption from FICA taxes was limited to those arrangements specifically designed to supplement state unemployment benefits as required by Rev. Ruls. 90-72 and 56-249 and that meet the other requirements of those revenue rulings. The appeals court therefore sustained the IRS’s denial of CSX’s FICA refund claims because CSX had not established that the separation payments satisfied the additional requirements for exclusion from FICA taxes set forth in the revenue rulings.

The Federal Circuit disagreed with the IRS’s argument that for FICA tax purposes, the term “wages” must be interpreted independently from its interpretation in the income tax withholding statutes. However, it also disagreed with the trial court’s conclusion that the reference to wages in Sec. 3402(o) meant that all payments that meet the definition of qualified supplemental unemployment benefits are nonwages for income tax withholding purposes and by extension for FICA tax purposes. Therefore, it held that Sec. 3402(o) did not override the IRS’s administrative requirements for supplemental unemployment benefits to be treated as nonwages in Rev. Ruls. 90-72 and 56-249.


According to the IRS, there are currently thousands of employers that have filed protective FICA tax refund claims in connection with separation payments to laid-off employees following the trial court’s decision in 2002. Nearly all of these claims, some for potentially hundreds of millions of dollars, have been referred to the IRS Service Center in Ogden, Utah, where they have been suspended.

The IRS has informally indicated that it intends to continue to challenge any CSX-based FICA refund claims that do not otherwise comply with the requirements of Rev. Rul. 90-72, in part because there is so much money potentially at stake.

A limited number of employers have filed perfected FICA refund claims with the IRS. In several cases, typically involving relatively smaller dollar amounts that were less closely scrutinized, the IRS actually paid these refund claims. The Service was recently successful in suing an employer in order to recover FICA taxes that had previously been refunded under an employer’s CSX-based FICA refund claim (JPS Composite Materials Corp., No. 6:06-cv-1743-GRA (D.S.C. 3/25/08)). Following its success in CSX, the IRS will very likely seek to recover other CSX-based FICA refund payments as well.

The CSX decision represents a significant victory for the government. However, this issue is likely to remain unsettled for at least several months longer. The CSX Corporation has the right to request a rehearing by the Federal Circuit, and it may ultimately appeal to the Supreme Court.

Even if CSX fails to appeal or is unsuccessful in its request for reconsideration, this appears to be far from a dead issue. Given the large dollar amounts potentially at stake, there is a good chance that another employer may bring a similar suit for refund in a U.S. district court (after first perfecting its refund claim). The decision in such a refund case would ultimately be appealable to a circuit other than the Federal Circuit and therefore could result in a split among the circuit courts. Under such a scenario, the uncertainty under which employers and practitioners have been living in connection with CSX-based FICA tax refund claims could potentially continue for years to come.


John L. Miller is a Faculty Instructor for Metropolitan Community College in Omaha, NE

Mr. Miller is a member of the AICPA Tax Division’s IRS Practice and Procedures Committee as well Faculty Instructor for Metropolitan Community College in Omaha, NE.

For further information about this column, contact Mr. Miller at

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