Both employees and employers are required to pay FICA tax on all wages—a broadly defined term. In today’s 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 employee’s 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 right—tenure. 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.