May 2002 > Tax Matters
B oth employees and employers are required to pay FICA tax on all wagesa broadly defined term. In todays economy, many workers are being laid off or asked to take early retirement. In some cases employees receive lump-sum payments to vacate their positions. Are these payment wages for FICA purposes?
North Dakota State University offered early retirement payments to tenured faculty members and to administrators. Eligible employees were those whose age plus years of service totaled at least 70. The university and each employee negotiated the actual payment, with a cap of 100% of the employees most recent salary. If an employee accepted the payment, he or she gave up any tenure, contract or employment right, any claim under the Age Discrimination in Employment Act and agreed not to seek employment with another North Dakota public university.
The university had received a letter from the Social Security Administration that the payments were not wages; therefore, it did not withhold or pay FICA taxes. The IRS assessed deficiencies. The university paid them and then requested a refund. The district court ruled the payments to the administrators were wages since they were at-will employees. However, the payments to faculty members were not because they were an exchange for a contract righttenure. The IRS appealed.
Result. For the taxpayer. Wages are defined as all remuneration for employment, with certain exceptions not relevant to this case. Although this is a very broad statement, it does not classify all income an employee receives from an employer as wages.
The court started with a review of the three relevant revenue rulings:
In revenue ruling 58-301, a lump-sum payment to an employee in his second year of a five-year contract to cancel the balance of the contract was not wages because it was in exchange for the relinquishment of contract rights.
In revenue ruling 74-252, a payment to an employee to cancel an employment contract pursuant to a contract provision that allowed cancellation with a payment of six-months salary was wages. In the North Dakota State case, the court distinguished this ruling from revenue ruling 58-301 on the grounds the payment was made under the terms of the contract whereas the one in revenue ruling 58-301 was to cancel an employment contract, which was a property right.
In revenue ruling 75-44, an employee received wages when he received a lump-sum payment to relinquish seniority rights he had earned under a general employment contract.
The university argued the payment it made to the faculty members was like the one in revenue ruling 58-301; the IRS argued it was more like the ones in revenue rulings 74-252 and 75-44.
Both parties admitted tenure was a property right under state law. However, the IRS argued it had no value and was similar to seniority and therefore wages. The court rejected both claims. It found tenure did have value even though it could not be sold to another employee. The court said tenure differs from seniority because it does not automatically accrue, not every faculty member receives tenure and it is based on factors such as research record, community service and the like and not just time in rank. Therefore, according to the court, tenure is a contractual right similar to the one in revenue ruling 58-301 and the payment was not wages. On the other hand, the payments to the administrators, who did not have tenure and could be fired at will, represented taxable wages.
On December 31, 2001, the Treasury Department nonacquiesed to the decision. It said the court misinterpreted the revenue rulings and that all of the payments were taxable wages. Future taxpayers should be aware of this position and the likelihood the Treasury will seek another case to litigate. To succeed in court, a taxpayer needs to come under revenue ruling 58-301 and not the other rulings. The payment needs to be in exchange for a contract right and not based on a provision in the contract. It must be based on a specific contract and not a general provision applicable to all employees. If it is, the taxpayer is likely to succeed.
North Dakota State University v. United States, 255 F3d 599, 87 AFTR 2d, p. 2001-1036 (CA-8).
Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.
T axpayers can deduct passive losses only to the extent they have passive income. If a taxpayer rents property to his or her wholly owned corporation, IRC section 469 generally categorizes this as a passive activity. However, when a taxpayer materially participates in the wholly owned corporation, Treasury regulations section 1.469-2(f)(6) recharacterizes the net rental income as nonpassive (the so-called self-rental rule). Transitional guidelines provide relief from this rule for rental agreements entered into before February 19, 1988. When a taxpayer rents property to one wholly owned corporation and another property to a different wholly owned corporation, regulations section 1.469-4(c)(1) allows the taxpayer to treat both rentals as one activity.
Thomas Krukowski was the sole shareholder of two C corporations, a health club and a law firm. He materially participated in the law firm. Krukowski owned two buildings he rented to the two corporations. The law office lease was signed in 1987 with a renewal option the firm exercised in December 1991. On their 1994 joint tax return, the taxpayer and his wife reported a passive loss of $69,100 from the building they rented to the health club and $175,149 of passive income from the building rented to the law firm. The return showed net passive income of $106,049. The IRS recharacterized the $175,149 of rental income from the law firm property as nonpassive based on the self-rental rule. As a result it disallowed the $69,100 passive loss from the health club building because the taxpayer did not have any passive income.
The taxpayer challenged this finding and the dispute reached the Tax Court. Taxpayer Krukowski made three arguments:
The self-rental regulation is invalid. Since sections 469(c)(2) and (4) specifically state that rental activities are passive, the Treasury secretary overstepped his authority when issuing the self-rental regulations.
The self-rental regulation did not apply because the lease was in effect before February 19, 1988. Leases in existence before this date were exempt from the self-rental rule.
Under proposed regulations available to taxpayers for 1994, shareholders could not participate in the activities of a C corporation. Therefore, the IRS reclassification of the $175,149 rental income as nonpassive was improper.
The Tax Court rejected all three arguments. The Krukowskis appealed the decision to the Seventh Circuit Court of Appeals, which had previously rejected the third argument in another case, Connor v. Commissioner, 2000-2 USTC 50,560.
Result. For the IRS. The Seventh Circuit agreed with the Tax Court that the self-rental regulation was valid. In the circuit courts opinion, section 469(l) gave the secretary the authority to classify otherwise passive income as nonpassive to meet the congressional goal of eliminating tax shelters. The Seventh Circuit joined the First and Fifth circuits in upholding the validity of the self-rental regulation. ( Sidell v. Commissioner, 2000-2 USTC 50,751; Fransen v. United States, 99-2 USTC 50,882.)
The Seventh Circuit also agreed the lease was not eligible for transitional relief since it was not in effect before February 19, 1988; under Wisconsin law, the exercise of the renewal option constituted a new lease entered into in 1991. In their appeal, the taxpayers also had argued that regulations section 1.469-4(c)(1) allowed them to treat both rentals as a single activity. The Seventh Circuit disagreed since the taxpayers had not clearly indicated on their 1994 return their intent to treat the rentals as a single activity.
The outcome of this case further strengthens the validity of the self-rental regulations. It also shows the importance of clearly indicating on a tax return the taxpayers intent to make a valid election.
Krukowski v. Commissioner, 2002-1 USTC 50,219.
Prepared by Charles J. Reichert, CPA, professor of accountancy, University of Wisconsin, Superior.