Tax Executive Institute Denver Chapter

1. Tax Executive InstituteDenver Chapter FICA Refunds on Severance Payments Mary (“Handy”) Hevener Morgan, Lewis & Bockius LLP October 23, 2013

2. FICA REFUND CLAIMS AND EXCEPTIONS FOR SEVERANCE/LAYOFFS/SUB PAY

3. Payroll Tax Refund Claims • Overview of Legal Arguments • FICA taxes are imposed on “wages” for “services performed” • SUB-Pay is exempt from FICA taxes • Statutory vs. IRS administrative definition of “SUB-Pay” • Quality Stores decision and Morgan Lewis’ role in filing two amicus briefs for the American Payroll Association, arguing case before the Sixth Circuit, and likely filing a third APA amicus brief as part of the Supreme Court brief (per the grant of certiorari on October 1, 2013).

4. Payroll Tax Refund ClaimsThe Legal Arguments • What Are Taxable “Wages”? • FICA “wages” are broadly defined as “all remuneration for services performed” • SUB-Pay benefits (as defined in a complex series of IRS “back and forth” revenue rulings issued since 1956) are not considered “wages” by the IRS, but most companies don’t pay severance from an IRS-approved SUB-Pay plan • Downsizing payments arguably do not constitute wages because they are not paid for the “performance of services” • Instead, downsizing payments are made because the employee has been prevented from performing services for a downsizing employer due to a reduction in force, plant shutdown, discontinuance of an operation, etc.

5. Background of the 1935 FICA/FUTA Act and the 1937 RRTA • During Congress’s debates from 1934-1937 accompanying the enactment of the FICA/FUTA taxes (in 1935) and the RRTA (in 1937), Congress was concerned that the many out-of work former employees, entitle to receive unemployment benefits under the legislation, might arrange for their former employers to pay FICA-taxed benefits relating to their former employment, thereby qualifying them for “wage history” needed to qualify for Social Security benefits. • This was called the “double-dip.”

6. IRS’s Narrow Ruling-based Exemption for “SUB Pay” • Starting in 1956 (with Rev. Rul. 56-249), the IRS issued a series of complex and internally inconsistent revenue rulings, exempting from FICA/FUTA a narrow class of “supplemental unemployment benefits,” but the IRS never maintained a consistent definition of these plans. • The IRS position changed repeatedly (in 5 additional rulings) over the years until 1990 (and the issuance of Rev. Rul. 90-72) on whether the benefits had to be in a trust, whether benefits had to supplement unemployment benefits, and whether benefits could vary with seniority and pre-termination wages.

7. Payroll Tax Refund Claims, cont. • Importance of 1968 final Treas. Reg. § 1.6041-2(b), requiring Form 1099-MISC reporting of SUB payments of “benefits because of [an employee’s] involuntary separation from employment (whether or not such separation is temporary) resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions.” This was the regulation Congress addressed in enacting Code § 3402(o)(2).

8. Payroll Tax Refund Claims:Statutory Definition of Involuntary Severance/Downsizing Pay • Congress in 1969 enacted Code § 3402(o)(2) (and other sections defining SUB-Pay): • Amounts paid to former employees • Pursuant to the employer’s plan or arrangement • On account of an involuntary separation • The involuntary separations must arise from: • a reduction in force, • discontinuance of a plant/operation, or • other similar conditions • The amounts are included in the employee’s gross income Note: No requirement that the employee stay unemployed to receive benefits

9. Limited Legislative History of 1969 Legislation • The Committee reports accompanying Code section 3402(o)(2) indicate that the provision had to be added because the described benefits were “not wages”. • Presumably, since the statutory language tracked exactly the 1968 information reporting regulation, Congress was reacting to the IRS’s regulatory classification of all these benefits as “not wages” – because they were subject to Form 1099 reporting. • The IRS/DOJ argued that the legislative history meant that the Congress was approving the IRS’s revenue rulings, and authorizing more rulings to be issued.

10. IRS Explanation of 1969 Act, in Form W-2 Instructions and Form 941 Instructions • Shortly after this new statute was effective, in its Form W-2 and Form 941 instructions for 1970, the IRS announced that, because of the new law, downsizing benefits had to be reported on Form W-2 and subjected to withholding – but were NOT subject to FICA/FUTA. • Those instructions were not included in more recent W-2 and Form 941 instructions, and the IRS archives do not include these forms. • The South Dakota University Archives kept the forms, and APA provided them to the 6th Circuit, showing the IRS’s contemporaneous interpretation of the 1969 law.

11. Rowan v. U.S. (1981 S. Ct Case) • In Rowan v. U.S., 453 U.S. 247 (1981), the Supreme Court concluded that any IRS regulations providing FITW exclusions should be automatically extended to FICA, even if no FICA regulation with a similar exclusion had been enacted. • Notably, this case addresses exclusions in REGULATIONS - not in statutes.

12. 1983 Social Security Amendments • In 1983, as part of the Social Security Amendments Act, Congress added a “Rowan override” – also called a “decoupling amendment,” providing that “nothing in the FITW regulations providing an exclusion from FITW wages shall be construed to require a similar exclusion from wages for FICA purposes. • Notably, this statutory provision also dealt with regulatory exclusions from FITW and FICA - not with statutory provisions. • No regulations have ever been issued under this amendment.

13. CSX Cases • In 2002, the Court of Federal Claims concluded that Code section 3402(o)(2) payments are exempt from FICA taxes. • Taxpayers immediately began filing FICA/FUTA refund claims. • In 2008, the Federal Circuit Court reversed the first CSX decision (but conceding that the law was “confusing”. • The Federal Circuit Court never saw the 1968 information reporting regulations.

14. Quality Stores cases • Shortly before the Federal Circuit’s decision in CSX, a bankruptcy judge in Ohio ordered a refund of FICA taxes on severance pay should be paid to Quality Stores. • After the Federal Circuit’s decision, the bankruptcy judge refused to change his order. • The order was appealed to the Ohio District Court, which affirmed the bankruptcy judge, concluding that amounts described in Code section 3402(o)(2) are exempt from FICA and FUTA. • The DOJ appealed, and APA filed an amicus brief.

15. Payroll Tax Refund Claims:Quality Stores Applies the Statutory Definition • Sixth Circuit Upholds Taxpayer’s Refund (9/7/2012) • Applies the statutory definition of SUB-Pay in Code § 3402(o). • Statutory SUB-Pay is not paid for services performed. • Recognizes that the FICA and FITW definitions of wages for SUB-Pay purposes should be identical since the IRS has not issued regulations under 1983 “decoupling amendment” overriding Rowan v. U.S. • Refused to apply the IRS’ most recent ruling in a series of inconsistent Revenue Rulings.

16. Petition for Rehearing • The DOJ argued, in its petition for rehearing of Quality Stores, (filed October 18, 2012) that the 3-judge panel misread the law. However, all the cases cited by DOJ were carefully considered by the panel. Also the DOJ’s brief once again does not mention the 1968 final regulation (effectively approved by Congress) that treated all SUB-Pay as “not wages.” • The DOJ will likely make the same arguments on appeal to the Supreme Court.

17. Response to Petition for Rehearing • QSI, through its counsel, responded that the original 3-judge panel correctly applied the law, and that no rehearing was necessary. • APA filed a second amicus brief, attaching IRS instructions from 1971 Forms W-2 and 941E (for the first full year of effectiveness of Code § 3402(o)(2)), explaining to taxpayers that the law change required severance/downsizing benefits to be subjected to FITW, but not to FICA/FUTA taxes. • Contemporaneous explanations are important tools of statutory interpretation.

18. Response to Petition for Rehearing and Cert Petition to Supreme Court • The government ‘s petition for rehearing en banc was denied by the Sixth Circuit on January 4, 2013. • The government filed a petition for writ of certiorari to the United States Supreme Court, which was granted October 1, 2013.

19. Response to Petition for Rehearing and Cert Petition to Supreme Court • This grant of certiorari will stay the pending cases, including: Alliant Techsystems, Inc. v. United States of America, Case No. 0:12-cv-00807-SRN-FLN (U.S.D.C. Minn.) Kimberly-Clark Corporation v. United States of America, Case No. 3:12-cv-01168-L (U.S.D.C. N. Tex.) Citigroup, Inc. v. United States of America, Case No. 3:12-cv-00591-JCH (U.S.D.C. Conn.) Citigroup, Inc. v. United States of America, Case No. 2:12-cv-00300-ALM-NMK (U.S.D.C. S. Ohio)

20. Response to Petition for Rehearing and Cert Petition to Supreme Court • The refund claims will also be frozen (although @ 1% are inadvertently paid), but companies should keep filing. • The government’s brief in Quality Stores is due on November 15, 2013 • We expect oral arguments in early 2014

21. Process to File • Data Collection: • The RIF plan (or at least the SPD explaining the involuntary layoff program); • Short description of the reasons for the layoffs, and an estimate of the numbers laid off; and • Best estimate of the amounts paid, and the FICA taxes over-collected. (Note: Variance)

22. Process to File (cont.) • Data Collection: • The Forms 941 (plus any later-filed Forms 941c or Forms 941-X) for the affected quarters in which the amounts were paid; • Claimant(s)’ filing district(s) for the Forms 941. • Amend for each Quarter • Entity by Entity Claims (can partially group) • Monitor Denials

23. Payroll Tax Refund ClaimsNext Steps • File refunds for open years (generally, 2010-2012) in anticipation of Supreme Court decision, IRS regulations and/or possible legislation. • File soon, to avoid potential legislation “clarifying” law and blocking claims post-introduction of such a bill. • Carefully monitor IRS denials of outstanding claims, and apply for extension of the deadline for filing suit in court (2 years after claim denial) by obtaining a signed “Form 907”.

24. Payroll Tax Refund ClaimsNext Steps (cont.) • Most claims are “frozen” in Appeals, or have been “returned to campus,” pending some IRS decision on how to handle the claims. • Steps to follow if IRS pays the refund (either per agreement at Appeals, like that reached by one MLB client, or per inadvertent refunds). • Do NOT pay severance free from FICA/FUTA until this matter is resolved. • Consider obtaining “consents” from employees at the point of severance, to simplify collection processes. • Possible issuance of explanatory employee letters to employees requesting a FICA exemption.

25. Other Procedural Issues • Perfection of Claims – through contacting employees – what does it entail, and when does it have to be done? • Reg. §31.6402(a)-2(a) • Rev. Rul. 81-310, • Rev. Rul. 2009-39 • Chicago Milwaukee v. U.S. • Macy’s NY v. U.S. • Entemann’s Bakery v. U.S. • Atlantic Department Stores v. U.S.

26. Other procedural issues, cont. • How formal must the IRS “denial” be to start the running of the two-year period allowed before a lawsuit? • If the claims have not been “perfected,” do the employees affected by the layoff have a continuing ability to file claims?

27. Morgan Lewis’s Alternative Fee Arrangements for QSI Refunds • Traditional Hourly, • Flat Fees, or • Alternative Fee Arrangement • No service fees unless the client receives refunds on its denied claims • Unique contingency fee equal to 5% to 15% of the refunds received (Depending on size of refund claim) • The percentage contingent fee is netted against any employee-share refund. • In the case of the employer-share refund, MLB fees for services rendered obtaining the refund are netted from the employer-share contingency fee • The net remaining employer-share contingency fee is held as a retainer to be used for future Morgan Lewis services at standard billing rates on matters that Morgan Lewis has not traditionally represented the client, over 3 years. 27

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29. Contact Info: Morgan, Lewis & Bockius Mary Hevener mhevener@morganlewis.com Phone: (202) 739 5982 74019979 74019979

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