Back Wages and Payment of FICA and FUTA

Back Wages and Payment of FICA and FUTA

Wage earners generally are required to pay FICA taxes in the year they receive their wages, computed at the applicable rates for that year. Likewise, employers are required to pay both FICA (IRC section 3111) and FUTA (IRC section 3301) in the year the wages are paid, again computed at the applicable rates. Confusion has arisen over whether an employer should compute taxes on back wages at the rate in effect when the wages were paid or the rate in effect when they were earned .

The Cleveland Indians baseball team owed back wages to 22 players for amounts earned during 1986 and 1987. In 1994, under a grievance settlement agreement, the Indians paid the wages. They also computed and paid employment taxes on the back wages according to the 1994 tax rates and wage bases. They then sued for a refund, claiming the wages should be treated as paid in 1986 and 1987 when no additional FICA or FUTA would have been due (since the players already had earned the maximum taxable amounts in those years).

The district court and Sixth Circuit Court of Appeals agreed with the taxpayer. The government requested certiorari and the U.S. Supreme Court agreed to hear the case because of the different results reached by various appeals courts.

Result. For the IRS. Employers should withhold and pay taxes on back wages using the applicable rates and wage bases for the year the wages are paid. Sections 3111(a) and (b) prescribe FICA tax rates applicable to “wages paid during” each year. Section 3301 sets the rates for unemployment taxes. IRC sections 3121(a) and 3306(b) set an annual ceiling on the wages subject to these taxes. Many questions in this and prior cases concerned the meaning of the term “wages paid.” All of the cases referred to a 1946 case, Social Security Board v . Nierotko, 327 U.S. 358, 370, where back wages were seen as “paid” in the year earned to determine eligibility for benefits.

The Cleveland Indians made several different arguments in support of their case. First, they said the ruling in Nierotko undermined a “plain language” argument since that case was decided in spite of the seemingly plain language used in the code. The Supreme Court agreed.

The team’s second point revolved around the theory that in order to achieve symmetry, the meaning of “wages paid” must be interpreted the same as in Nierotko . The Court rejected this argument because Nierotko concerned assessing benefits eligibility not taxes paid.

The Cleveland Indians further maintained that Congress had ratified Nierotko in an amendment passed shortly after the court decided that case. The Supreme Court rejected this third argument, saying the amendment’s purpose primarily was to set a “yardstick” for measuring wages for FICA and FUTA for administrative convenience, not to ratify allocations concerning back pay.

Finally, the taxpayer claimed that not allocating the wages to the year the players earned them created an inequity in taxation. The Court also disagreed with this argument. In Nierotko , the judgment occurred because applying the language in the law strictly would have resulted in unfairness to the taxpayer since this assessment could only have been to the employee’s disadvantage. However, when paying taxes, the situation could work to either the taxpayer’s advantage or disadvantage. Thus, the current judgment was seen as fair.

The Court went on to say that even though the tax code and regulations did not specifically address back pay, courts usually deferred to prior government practices as long as the rules were applied fairly and in a reasonable manner. Since 1940, the regulations have used the rule of paying taxes on wages in the year they were paid. A taxpayer would need to prove this had been done in an unreasonable manner before a court would overturn it.

All employers must withhold and pay employment taxes based on the wage base and rates in effect in the year they pay wages. Very few tax planning opportunities are available when dealing with wages earned in a prior year. If a taxpayer is suing for back wages, prelitigation planning could involve a payment schedule to aggregate all payments into a specific year or spread the payments out over a period of years, based on the employer’s and employees’ tax situations. CPAs also could point out that, for the FICA portion only, employees sometimes will be entitled to a credit for excess Social Security payments because of other earnings. The parties could use this as a bargaining point during litigation.

United States v . Cleveland Indians Baseball Co., 87 AFTR2d 2001-1706.

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