Circuit Courts Further Define ‘Wages’ for Employment Tax Purposes

September 21, 2012Articles The Legal Intelligencer

Two recent circuit court decisions have further refined the definition of "wages" for purposes of Federal Insurance Contributions Act employment taxes. In Watson v. Commissioner, 668 F. 3d 1008 (8th Cir. 2012), the U.S. Court of Appeals for the Eighth Circuit affirmed a federal district court's decision recharacterizing a substantial portion of dividend distributions made by an S-corporation to its sole shareholder as wages for FICA purposes. In United States v. Quality Stores, 110 AFTR 2d ¶2012-5253 (CA6 9/7/12), the Sixth Circuit affirmed the decision of the U.S. Bankruptcy Court for the Western District of Michigan in holding that severance payments made to the terminated employees of a bankrupt employer were not wages for FICA purposes.

Pursuant to FICA, every employee and self-employed individual must pay taxes on his or her wages or self-employment income to fund Social Security and Medicare. The taxes on employees, contained in Sections 3111(a) and (b) of the Internal Revenue Code of 1986, are imposed "on every employer ... with respect to individuals in [its] employ," and are calculated as a certain percentage of wages the employer pays "with respect to employment." The total tax rate paid by both employees and employers is 7.65 percent. This is made up of a 6.2 percent contribution to the Old-Age, Survivors and Disability Insurance (OASDI) program and a 1.45 percent contribution to Medicare's hospital insurance program. The OASDI portion is only imposed upon the first $110,000 of "wages" paid (i.e., the "taxable wage base"), and for 2012, the OASDI tax rate of 6.2 percent for employees is temporarily reduced to 4.2 percent pursuant to relief originally effective in 2011. Section 3121(a) defines "wages" for FICA purposes (with certain exceptions) as "all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash."

In Watson, David Watson was an accountant who was the sole shareholder, director, officer and employee of an S-corporation (Watson P.C.) that was, in turn, a 25 percent partner in a significant accounting firm located in West Des Moines, Iowa. In the two tax years at issue (2002 and 2003), the accounting firm paid Watson annual compensation of $24,000. In addition, in each of those years, the accounting firm made substantial "profit" distributions to Watson P.C. ($203,651 in 2002 and $175,470 in 2003). These profit distributions were subsequently distributed to Watson by Watson P.C. as dividends and no FICA or income taxes were withheld. The IRS asserted that a portion of the S-corporation distributions characterized as dividends should have properly been treated as wages subject to FICA taxes.

As an initial matter, the court in Watson stated that whether payments to a shareholder represent compensation for services rendered that would constitute wages or a distribution of profits that would not constitute wages subject to FICA is a "matter purely of fact." Moreover, the court noted that an IRS assessment of taxes due is entitled to a legal presumption of correctness and the taxpayer bears the burden of proving that the IRS assessment is wrong.

In Watson, the IRS essentially relied upon Revenue Ruling 74-44, 1974-1 C.D. 287, in which an S-corporation distributed dividends to its two shareholder-employees but did not pay any wages for their services. In the ruling, the IRS concluded that it could recharacterize the nature of the "dividend" payments as "wages" for FICA tax purposes, because it was established that the dividends paid to the shareholders were in lieu of reasonable compensation for their services. Similarly, the IRS cited the case of Radtke v. United States, S.C., 712 F. Supp. 143 (E.D. Wis. 1989), Aff'd Per Curiam 895 F. 2d 1196 (7th Cir. 1990), in which the district court recharacterized dividends paid to the sole shareholder of an S-corporation as wages for FICA purposes where a substance-over-form analysis indicated that the payments were clearly remuneration for services performed.

In Watson, the IRS relied upon an expert witness who opined that approximately $91,000 of the total annual distributions received by Watson represented "reasonable compensation" for the services that he performed on behalf of the accounting firm. The Eighth Circuit noted a variety of factors that supported this opinion, including Watson's qualifications as an accountant and his advanced accounting degree and years of experience, the profitability of the accounting practice, the extensive hours worked by Watson and the relationship of the $24,000 claimed as annual compensation in comparison to the levels of compensation paid to other accountants at the firm, according to the opinion.

While the Eighth Circuit in Watson concluded that a portion of the payments at issue should be recharacterized as wages subject to FICA based upon a substantive analysis of the facts, the Sixth Circuit in Quality Stores relied upon statutory construction and legislative history in concluding that the payments involved in that case were not wages subject to FICA.

Quality Stores was a large agricultural specialty retailer that went into Chapter 11 bankruptcy in 2001. Prior to its bankruptcy, Quality Stores engaged in a substantial reduction in force and adopted a prepetition severance plan that provided severance pay to executive and management-level employees. The company also adopted a post-petition severance plan for rank-and-file employees to encourage employees to remain employed by the company until the liquidation of the company and the formal elimination of their jobs. The payments made under both the prepetition and post-petition severance plans were not tied to the receipt of state unemployment compensation, nor were they attributable to the provision of any particular services, according to the opinion.

Quality Stores reported the payments under both severance plans as wages on W-2 forms and paid the employer share of FICA tax and withheld each employee's share of FICA tax. In total, $1.125 million in FICA taxes were paid. Quality Stores filed a refund on its own behalf and on behalf of 1,850 former employees in an attempt to recover the FICA taxes paid. On stipulated facts, the bankruptcy court ordered the IRS to make a full refund of the FICA taxes paid.

The singular issue before the Sixth Circuit was whether the severance payments constituted wages. The first aspect of this issue was whether severance payments could be considered wages, because they were not necessarily remuneration for services rendered. The Sixth Circuit, relying upon prior case law, concluded that the employer-employee relationship was to be broadly construed and any payments made pursuant to this relationship, including its termination, were eligible to be considered as wages for FICA purposes.

In analyzing the severance payments, the Sixth Circuit noted that neither the statutory provisions relating to FICA nor the regulations promulgated thereunder expressly include or exclude severance payments from the definition of wages. However, the court noted that Congress excluded, by implication, "supplemental unemployment benefits" from the definition of wages for income tax withholding purposes pursuant to Section 3402. Section 3402(o) is a subsection titled, "Extension of Withholding to Certain Payments Other Than Wages" and provides that amounts paid to an employee are subject to income tax withholding "as if" they were wages paid pursuant to a plan because of an employee's "involuntary separation from employment ... resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions, but only to the extent such benefits are includable in the employee's gross income."

To the Sixth Circuit, the language of Section 3402(o), specifically the treatment of supplemental unemployment benefits "as if" they were wages was determinative that such payments were not wages for FICA purposes. The court specifically held that the "necessary implication arising from this phrase is that Congress did not consider supplemental unemployment payments to be wages, but allowed them to be treated as if they were wages under Code Section 3402(o) to facilitate more efficient tax administration through withholding." The Sixth Circuit also cited the Supreme Court decision in Rowan Companies v. U.S., 452 US 247 (1981), for the proposition that Congress intended a uniform definition of wages for both income tax withholding and FICA purposes.

Because the Sixth Circuit conceded that there could be ambiguity as to whether the supplemental unemployment were wages, the court stated that it could rely on aids to statutory construction to help resolve the ambiguity. In this regard, the court specifically referred to the title of Section 3402(o), as well as the legislative history of Section 3402(o), which explicitly states that supplemental unemployment benefits would not constitute wages subject to withholding absent this statutory provision, which treats such payments as if they were wages.

It should be noted that the holding of the Sixth Circuit in Quality Stores is contrary to the holding of the Federal Circuit in CSX v. United States, 518 F. 3d 1328 (Fed. Cir. 2008). In addition, in published Revenue Ruling 90-72, 1990-2 C.D. 211, the IRS maintained that for severance payments to be exempt from FICA, such payments must be made to involuntarily separated employees pursuant to a plan that it is designed to supplement the receipt of state unemployment compensation.

For many individuals, especially lower-earning employees, FICA taxes often represent a significant portion of their tax burden. Therefore, whether payments constitute wages for FICA purposes is vitally important. In the case of severance payments, the IRS has not relinquished the fight and this issue is likely headed to the Supreme Court as a result of the different positions established by the Sixth Circuit and the Federal Circuit. In the case of payments to shareholder-employees characterized as dividends, the IRS can also be expected to remain vigilant in attempting to recharacterize these payments as wages.

Reprinted with permission from the September 21 issue of The Legal Intelligencer. (c) 2012 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.