I mentioned early last year that the Supreme Court's Mayo decision had strengthened the IRS's position, by saying that courts usually have to defer to IRS regulations instead of deciding for themselves what the law means. But there are limits to deference; a Sixth Circuit case last month was a recent demonstration.
Quality Stores involved a question of payroll taxes on severance payments to terminated employees. The government argued that those payments were "wages" subject to payroll taxes. The employer had withheld income tax from those payments, but argued that payroll taxes (Social Security, Medicare, unemployment tax) did not apply. The court agreed with the taxpayer. It was a fairly typical case in that the answer was not clearly established by Congress in the law they passed. The court had to go through a complex analysis to reach the answer:
- The Internal Revenue Code states that "wages" are subject to payroll taxes.
- A different part of the Code states that "wages" are subject to income-tax withholding, and the two definitions of "wages" are vitually identical.
- A provision for income-tax withholding specifically requires withholding from payments "other than wages" by an employer when employees are terminated. [Section 3402(o)] These payments are subject to withholding, but they are not "wages."
- A Supreme Court case from 1981, Rowan, had concluded that generally "wages" should be interpreted the same way for income-tax withholding and payroll taxes.
- Therefore, the implied definition in Section 3402(o) of what is not "wages" for purposes of income-tax withholding also defines what is not "wages" for purposes of payroll taxes.
- The payments by Quality Stores to its former employees met the definition in Section 3402(0) and therefore were not "wages" subject to payroll taxes.
That was also consistent with the purpose for such payments, when the concept arose in the 1950's. Unemployment benefits only replaced a portion of pre-severance earnings; these plans were intended to raise the portion of earnings replaced and provide income security. Because the payments were taxable income, it made sense to withhold income tax. But treating them as "wages" would result in disqualification from unemployment benefits in many states. So the result in Quality Stores was entirely reasonable.
But the IRS disagreed, and raised some interesting deference questions.
First, the government argued that Rowan -- relied on to apply the definition of "not wages" for income-tax withholding to payroll taxes as well -- was no longer good law, as a result of the decision in Mayo. Rowan had applied a less-deferential standard to regulations issued by the IRS than Mayo required. I suspect that the actual result in Rowan might have changed under the more-deferential standard. In that case, there were regulations that supported the government's position, but the court made its own decision to the contrary instead of deferring to the IRS regulations. Under the standard in Mayo, the result might have changed.
But the Sixth Circuit decided in Quality Stores that this didn't matter. The general principle that "wages" should be interpreted the same way in both parts of the Code was still valid, and there were no IRS regulations covering severance payments. No regulations, no deference.
Second, the government argued that the IRS had issued a series of Revenue Rulings that established a difference between "supplemental unemployment compensation benefits" ("SUB") and "dismissal pay." SUB payments are not subject to payroll taxes, but dismissal pay is. And the Rulings established a definition for SUB payments that is different from the definition in Section 3402(o). The Federal Circuit adopted the definition of SUB pay set out in the Revenue Rulings, in the CSX Corp. case. But the Sixth Circuit disagreed. It concluded that revenue rulings are not entitled to the same level of deference as actual regulations. [*] In this case, without any regulations addressing the issue, it used its own interpretation of the law rather than the IRS interpretations in the Revenue Rulings.
The precise limits of deference to IRS interpretations of the law will take many, many years to work out -- if they ever are.
[*] In part, this is because agencies are normally required to follow "notice and comment" procedures when establishing rules that are meant to have the force of law and to be entitled to deference. The IRS often, but not always, follows those procedures when issuing Regulations but does not when it issues Revenue Rulings. Many courts have concluded, as the Sixth Circuit did, that Revenue Rulings are not entitled to deference. The Supreme Court did not directly address this question in Mayo.