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Business Costs & Regulation

A Tax Win for Downsizing Firms

Laid off workers also gain in a stunning district court decision.

Good news for businesses that are downsizing or already have: You may be due money back from the IRS. A district court has ruled that severance pay given to terminated workers is not subject to Social Security and Medicare taxes. Workers who had taxes deducted from their severance could also get that money back.

Don’t go spending your refund yet, however. The IRS is certain to appeal the ruling, so the fight on this issue is far from over. But you can protect your interests by filing what’s known as a protective refund claim, using IRS Form 843. The IRS will set these claims aside until after all appeals are decided. Claims can be filed by firms that paid severance to laid off workers within the three-year statute of limitations for tax returns. Acting quickly is especially important for businesses that paid severance back in 2006 because the statute-of-limitations window for them will run out next month, on April 15.

The case in question involves a retailer that closed all its stores and let its staff go, paying them severance. The retailer challenged IRS’ finding that Social Security and Medicare taxes were owed on the payments, and the U.S. District Court for the Western District of Michigan sided with the store. The court noted that the tax code specifically requires employers to treat severance paid to laid off workers as if it were wages for income tax withholding purposes. In the court’s view, this indicates that severance pay is not otherwise to be treated as a payment of wages, and thus is exempt from payroll tax. The court also disagreed with the IRS’ position that severance pay avoids the tax only if that pay is tied to receipt of unemployment benefits.

If the IRS loses all appeals, employees also would get back their portion of Social Security and Medicare taxes. Employers and employees are both responsible for half of the tax that must be deducted from paychecks and remitted to the government. Employers can choose to file a protective refund claim just for their half, but they may opt instead to file for the employee’s half, too. In the latter case, they could file one of two ways: They could either remit the employee half to the worker before filing a claim and then keep the entire amount of the refund when and if it ultimately comes. Or they could get written consent from workers to file for their half and agree to remit that portion to workers after receiving the funds from IRS. Employees can file protective refund claims on their own for their half of the tax if they don’t want their former employer to file for them.

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For companies considering downsizing in the future, watch the court proceedings carefully, but keep paying your taxes. Until the appeals process is exhausted, IRS still has the right to demand timely payment of Social Security and Medicare taxes on severance pay.


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