Supplemental Unemployment Compensation Benefits Not Subject to FICA

By James A. Beavers, J.D., LL.M., CPA, CGMA

Employment Taxes

The Sixth Circuit held that supplemental unemployment compensation benefit payments were not wages for FICA purposes and therefore not subject to FICA.


Quality Stores was the largest agricultural-specialty retailer in the country, serving farmers, hobby gardeners, skilled trade persons, and do-it-yourself customers. In October 2001, the company went into Chapter 11 bankruptcy. As a result of the bankruptcy, the company discontinued operations and eventually terminated all its employees.

Quality Stores made severance payments to the involuntarily terminated employees. The severance payments resulted directly from a reduction in force or the discontinuance of a plant or operation. Quality Stores made the severance payments pursuant to a prebankruptcy petition plan and a post-bankruptcy petition plan.

Quality Stores reported the payments from both plans as wages on the employees’ W-2 forms and withheld federal income tax. Quality Stores also paid the employer’s share of FICA tax and withheld each employee’s share of FICA tax. For the taxable quarters ending Dec. 31, 1999, through June 30, 2002, Quality Stores filed timely Forms 941, Employer’s Quarterly Federal Tax Return, reporting wages paid to employees and remitted the applicable FICA taxes.

Although Quality Stores collected and paid the FICA tax, it did not agree with the IRS that the severance payments constituted wages for FICA purposes. Quality Stores took the position that the payments made to its employees pursuant to the plans were not wages but instead constituted supplemental unemployment compensation benefit payments (SUB payments) that were not taxable under FICA. Quality Stores asked 3,100 former employees to allow the company to file FICA tax refund claims on their behalf. Of those contacted, 1,850 former employees allowed the company to pursue FICA tax refunds for them.

In September 2002, Quality Stores timely filed with the IRS 15 Forms 843, Claim for Refund and Request for Abatement, seeking the refund of $1,000,125 in FICA tax. This amount consisted of $571,127 for the employer’s share and $428,998 for the employees’ share attributed to those employees who granted the company consent to pursue their claims. When the IRS did not allow or deny the refund claims, Quality Stores filed an adversary action in the bankruptcy court in June 2005.

The bankruptcy court held in favor of Quality Stores and ordered a full refund of the FICA taxes paid (In re Quality Stores, Inc., 383 B.R. 67 (Bankr. W.D. Mich. 2008)). A district court affirmed (Quality Stores, Inc., 424 B.R. 237 (W.D. Mich. 2010)), and the IRS appealed the decision to the Sixth Circuit.

The Sixth Circuit’s Decision

The Sixth Circuit held that the payments under the plans were SUB payments and that, as such, they were not wages for FICA tax withholding purposes. The court, citing Sec. 3402(o), found that SUB payments were not wages for purposes of income tax withholding. Based on the Supreme Court’s decision in Rowan Cos., 452 U.S. 247 (1981), the court then found that the term wages had the same meaning for FICA and federal income tax withholding. Thus, it concluded that the SUB payments were not wages for FICA tax purposes.

Sec. 3402(o), Extension of Withholding to Certain Payments Other Than Wages, specifically applies to, among other things, “any supplemental unemployment compensation benefit.” The court first noted that the inclusion of the phrase “other than wages” supported the conclusion that the statute applied to nonwage payments. The court also cited several passages in the legislative history of Sec. 3402 that specifically stated that SUB benefits are not wages. Thus, it determined that Congress had enacted Sec. 3402(o) to extend federal income tax withholding to certain nonwage payments and that SUB payments were nonwage payments.

Having determined from this analysis that SUB payments were nonwage payments for income tax withholding, the court determined, based on the Rowan decision, that they must be nonwage payments for FICA purposes. In Rowan, the Supreme Court held that, by adopting virtually identical definitions of wages in Sec. 3121 (for FICA) and Sec. 3401 (for federal income tax withholding), Congress intended the term “wages” to have the same meaning for both purposes. Consequently, if SUB payments were not wages for purposes of federal withholding tax, they were not wages for purposes of FICA.

The IRS argued that Rowan did not apply because Congress legislatively superseded Rowan when it enacted the “decoupling amendment” as part of the Social Security Amendments of 1983, P.L. 98-21. The pertinent part of the decoupling amendment reads:

Nothing in the regulations prescribed for purposes of chapter 24 (relating to income tax withholding) which provides an exclusion from “wages” as used in such chapter shall be construed to require a similar exclusion from “wages” in the regulations prescribed for purposes of this chapter [22 relating to FICA].

According to the IRS, the decoupling amendment severed the connection between the definition of wages for FICA and for income tax withholding. The Sixth Circuit rejected this argument, explaining that, while the legislative history of the amendment expressed this intent, the amendment’s actual language did not provide that wages must be treated differently for FICA and income tax withholding. Instead, according to the court, the language of the amendment only addressed the construction of the regulations regarding FICA and income tax withholding, stating that the IRS could promulgate regulations that provided for different exclusions from wages for each purpose. But, as the court pointed out, the IRS has not issued any regulations under the decoupling amendment. Therefore, the court found that under a plain reading of the decoupling amendment, Congress had not statutorily superseded Rowan and the case remained good law.

The IRS argued as a fallback position that, even if Rowan remained good law, the result reached by the bankruptcy court was inconsistent with Rowan. The IRS contended that, while the Supreme Court construed the FICA and income tax definitions of “wages” similarly in order to effectuate a congressional intent to promote “simplicity and ease of administration,” here the bankruptcy court’s decision resulted in different treatment of SUB payments for purposes of FICA and income tax withholding, which was the situation the Supreme Court sought to avoid.

The Sixth Circuit found that this was not the case. The court explained that reading the definitions of “wages” found in the FICA and federal income tax statutes consistently, SUB payments do not constitute “wages” under either statutory scheme. The difference in treatment in this case was a result of Congress’s imposition of federal income tax withholding on SUB payments because they qualified as gross income, not because they were wages.


The IRS had also argued, based on a number of revenue rulings, that the payments made by Quality Stores were not SUB payments, but rather were “dismissal payments” that were includible in income as wages. The court disregarded these revenue rulings, finding that they were inconsistent with congressional intent as expressed in the statutory definition of SUB payments in Sec. 3402(o) and the section’s legislative history. The court noted that, similar to a regulation, a revenue ruling has no power to alter a statute enacted by Congress.

In re Quality Stores, Inc., No. 10-1563 (6th Cir. 9/7/12)

Tax Insider Articles


Business meal deductions after the TCJA

This article discusses the history of the deduction of business meal expenses and the new rules under the TCJA and the regulations and provides a framework for documenting and substantiating the deduction.


Quirks spurred by COVID-19 tax relief

This article discusses some procedural and administrative quirks that have emerged with the new tax legislative, regulatory, and procedural guidance related to COVID-19.