TAX CASE

he courts have uniformly held that generally accepted accounting principles (GAAP) are not determinative of tax rules. Whether a taxpayer recognized income for financial statement purposes is irrelevant in deciding whether he or she must report the income on a tax return. The Ninth Circuit Court of Appeals recently analyzed when a taxpayer must report a cash advance volume discount as income.

Westpac, a partnership formed by three grocery store chains to purchase and warehouse inventory, signed four contracts, each specifying a quantity of inventory to be purchased. Each contract also provided Westpac a cash advance and a repayment obligation on a pro rata basis if the partnership failed to purchase the quantity specified. Westpac booked the advances as liabilities, and it reduced the cost of goods sold by a percentage of the advance as goods were purchased. The government reclassified the advances as income when received. The Tax Court sided with the IRS and held that Westpac should have reported the advances as income. The taxpayer appealed the decision.

Result. For the taxpayer. The question before the court was whether a discount received in the form of a cash advance was income in the year received. The court found Indianapolis Power & Light Co. and Automobile Club of Michigan provided the answer, though neither one was exactly on point.

In Indianapolis Power, 493 US 203, the Supreme Court ruled that a deposit was not income because there was an obligation to repay the money when the services ended. In Automobile Club, 353 US 180, the prepaid membership dues were income when received because a pro rata recognition of the dues would not match income with expenses and the taxpayer was entitled to keep the dues even if no services were demanded.

In the Westpac case, the advance had to be repaid if volume requirements were not met. Therefore the case was closer to Indianapolis Power than to Automobile Club. The fact that the amount of the repayment might be less than the total advance did not change the analysis or the outcome.

The decision in Westpac was based on tax accounting principles. The fact that GAAP requires the cash to be reported as income when the volume requirements are met was immaterial. The court also referenced the prior case of Milenbach in order to remind taxpayers the repayment obligation must be real and enforceable or it will be disregarded in reaching the tax outcome.

This decision clarifies the requirements for taxable income. A taxpayer must realize an increase in wealth and have complete control of the cash. An increase in wealth does not exist as long as there is an obligation to return the cash based on future performance or nonperformance.

Westpac Pacific Food v. Commissioner, 2006-2 USTC ¶50,369 (CA-9).

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

TAX CASE

ny cash or noncash remuneration received for employment, unless specifically exempt, is considered wages subject to the FICA tax. FICA wages can include amounts received by the employee after the employment relationship has ended. For example, the courts have held that awards for back pay and future pay to wrongfully terminated employees were FICA wages since the payments were a result of the employee-employer relationship. Payments to employees who voluntarily accepted severance pay while waiving all seniority, litigation and future employment rights also have been considered FICA wages by the courts.

But, in North Dakota State University v. United States, 84 FSupp2d 1043, the Eighth Circuit Court of Appeals held that amounts received by tenured professors who relinquished their tenure rights under an early retirement program were not FICA wages. Also, the U.S. Court of Federal Claims, in CSX Corporation v. United States, 52 Ct. Fed. Cls. 208, held that supplemental unemployment compensation benefits (SUB) were not FICA wages. The following describes how the CSX case and another—on payments to tenured teachers—played out in the appeals courts.

Severance pay to tenured teachers. Donald Appoloni, Russell Bergmann, Charles Engle, Phyllis Klender, Roger Petri and William Rase were tenured public school teachers in three school districts in Michigan. The Michigan Teacher’s Act automatically grants tenure to public school teachers after a four-year probationary period. When the school districts offered early retirement packages to teachers who had served a minimum number of years, all six accepted and, except for Rase, waived all future employment rights as part of the plan. The school districts withheld FICA taxes on the payments; Appoloni, Bergmann and Engle sued for a refund in the Western District Court of Michigan, and Klender, Petri and Rase in the Eastern District Court.

The Eastern District Court ruled in favor of the taxpayers, saying the payments were not for past, present or future services but rather payments for not working. Since the teachers had a statutory right to continue to teach, the payments received to give up those rights were not remuneration for employment. The court cited the North Dakota State decision and revenue ruling 58-301 (1958-1 CB 23) in which the IRS held that the buyout of a taxpayer’s remaining rights in the second year of a five-year contract was not subject to FICA.

The Western District Court, however, ruled the payments were FICA wages since they had been made because of the teachers’ employment relationship with the school district and would have been received by the taxpayers had they continued teaching. The court also distinguished this situation from revenue ruling 58-301, stating the tenure rights had been acquired through service to the school district as opposed to having been acquired contractually at the beginning of their employment period. Furthermore, the court saw no reason to distinguish tenure rights from other ones, such as seniority or litigation rights, when those rights are relinquished to receive severance pay. The taxpayers appealed the decision to the Sixth Circuit Court of Appeals where this case was consolidated with the IRS’s appeal of the Eastern District Court’s decision.

Separation payments to employees. CSX Corp. also disputed the IRS’s claim that certain payments were FICA wages. When CSX reduced its workforce, the company and its employees’ union agreed to a forced transfer arrangement under which laid-off employees were allowed to choose among three options: They could transfer to a new location and come back to work for CSX, remain laid-off and forfeit any further temporary benefits while retaining their employment rights, or leave the company after receiving a lump-sum payment. CSX paid FICA taxes on those separation payments, but sued for a refund in Federal Claims Court disagreeing with the IRS’s position that employees who chose the last option were subject to the FICA tax.

Results. For the IRS in both the Michigan teachers case and the CSX case. In the Michigan teachers’ case, the Sixth Circuit held that eligibility requirements were the most accurate test to determine whether payments were FICA wages. To be eligible for the payments, the taxpayers needed a minimum number of years of service—indicating the payments were for services performed rather than for the exchange of tenure rights. The Sixth Circuit also agreed with the Western District Court that it could not distinguish tenure rights from any other rights an employee might earn while working, such as seniority rights or litigation rights. The Sixth Circuit also stated that the primary reason the school district made the severance payments was to provide an incentive for highly paid teachers to retire and that the exchange of the tenure rights, although necessary for that to happen, was secondary.

One judge dissented, agreeing with the Eighth Circuit’s reasoning; however, based on that reasoning, the judge said, Rase’s payments still were FICA wages since he had accepted the severance pay without relinquishing his tenure rights. The case put the Sixth and Eighth Circuits into conflict over this issue and unfortunately created uncertainty for taxpayers in other circuits.

In the CSX case, the taxpayer had argued that the payments were SUB payments because the employees receiving them had already been laid off and these payments had simply changed the employees’ involuntary separation status from indefinite to permanent. The IRS argued the benefits package gave employees the option of returning to work at CSX if they transferred to a new location; therefore, employees electing the separation option had voluntarily terminated their employment and the payments did not qualify as SUB payments.

In the court’s opinion employees who chose not to relocate had voluntarily left their employment. The court noted the employees’ decision was the same as that of employees who, because they feared a forced transfer, had left the company voluntarily prior to the layoff. These payments did not qualify as SUB payments because they did not result from the employees’ temporary or permanent involuntary separation from their employer and were, therefore, subject to the FICA tax.

The CSX case is consistent with most prior findings—although not with North Dakota State—that FICA wages include payments to employees who elect to terminate their employment.

Donald F. Appoloni, Sr. v. United States, 450 F3d 185.

CSX Corporation v. United States, Ct. Fed. Cls. 95-858T.

Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.

TAX CASE

RC section 6511(a) generally requires taxpayers to file a refund claim for a tax overpayment within three years from the time the return was filed or within two years from the time the tax was paid, whichever period expires later. If no return was filed, the two-year period applies.

Wachovia Bank was the trustee for the George C. Nunamann Trust, a tax-exempt charitable remainder trust. Wachovia erroneously paid taxes totaling $111,823 for the trust for the years 1997 and 1998. After discovering the error, it attempted to recover the amounts. The IRS denied the requests because they were not filed within the three-year period prescribed in section 6511(a). Wachovia sued in district court, which, after hearing the case, held for Wachovia and the tax refund. The IRS appealed to the 11th Circuit Court of Appeals.

Result. For the IRS. Wachovia’s argument, presented in both the district and appeals courts, was that the statute of limitations does not apply to tax-exempt entities that are not required to file a return. Therefore, the general six-year statute of limitations (outside the tax code) to file suit against the federal government applied. The district court agreed and ordered a tax refund.

In its arguments before the appeals court, the IRS maintained that section 6511(a) must be interpreted in conjunction with IRC section 7422 and regulations section 301.6511(a)-1. Section 7422 requires that before a taxpayer can sue to recover funds “wrongfully collected,” an administrative claim for refund must be filed in accordance with the relevant regulations. If the section 7422 requirements are not met, then a court does not have jurisdiction in the refund claim.

The IRS argued that section 6511(a) and regulations section 301.6511(a)-1 distinguish between refunds payable by return and those payable by stamp. A tax not payable by stamp (which was the case here) falls into the return category. Applications for the refund of overpayments in the return category are subject to the three-year limitation. The district court noted that taxes paid erroneously under section 6401(c) were overpayments. Therefore, these amounts automatically fell under other provisions of the tax code.

The appeals court concluded that because Wachovia did not file its refund claims within the three-year limitation under section 6511(a), the district court, under section 7422, did not have jurisdiction. It said Wachovia erroneously overrelied on 13 words in section 6511(a): “in respect of which tax the taxpayer is required to file a return.” The IRS and appeals court found the meaning of the term taxpayer in this context ambiguous. To resolve this ambiguity, the court considered the term within the context of the applicable code section and the specific situation.

Taxpayers must be careful not to view the tax code or regulations in isolation. It is clear Congress intended them to be considered as an entirety.

Wachovia Bank, N.A. v. United States, 98 AFTR2d 2006-5111.

Prepared by Sharon Burnett, CPA, PhD, associate professor of accounting and Darlene Pulliam, CPA, PhD, professor of accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.