Certain Tax Issues Concerning Employee Termination Fees

By Mark A. Segal

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JULY 2007 - Tax law imposes significant financial and administrative duties on employers with respect to payroll taxes. Critical to such duties is the payment of wages. According to IRC sections 3121 and 3401, wages are generally understood to encompass “all remuneration, for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash.” The expression “employment” is defined broadly as “any service, of whatever nature, performed by an employee for the person employing him.” In recent years, controversy has emerged concerning the tax treatment of amounts paid in the termination of services. If the amounts are determined to be wages, the payments will trigger withholding-tax obligations (at both the state and federal level) and employer matching payments for certain taxes (i.e., FICA and FUTA) paid out of the employee’s paycheck. Typically, if instead the amounts paid are considered income to the recipient but not wages, the employer will be relieved of withholding (administration) and matching duties.

Proper classification of such payments is crucial, because failure to properly treat such amounts can result in the payer being subject to significant penalties and interest. Taxpayers often pay the taxes even when they believe they are not responsible for them, and then sue for a refund. Whether these duties are applicable and have been appropriately carried out hinges upon a determination of the relationship between the worker and the party for whom the work was performed, and the basis for the recipient having been paid. Recently, payroll tax disputes have centered on the classification of certain payments associated with termination or severance from service, and for tenure rights.

Definition of Wages

Courts have tended to find payments associated with the termination of services to constitute wages. As wages, such amounts would typically be subject to payroll tax obligations. In many instances, however, such taxes have been imposed on amounts received for other than what one would consider to be services. For example, in Social Security Board v. Nierotko (327 US 358), back pay for a worker who had been wrongfully separated from his job and did no actual work during the period was found subject to payroll taxes. Other cases citing Nierotko have found FICA and FUTA taxes applicable to unlawful termination payments for past and future earnings, and when the employer entered into a termination settlement to avoid paying retirement benefits. [See Grebec, 164 F.3d 1015 (6th Circuit), and Mayberry, 151 F.3d 855.]
Not all payments made to a worker in connection with employment have been found to constitute wages. For example, certain meal reimbursements or qualified allowance arrangements will be considered neither wages nor subject to FICA or FUTA. (See Central Illinois Public Service Company, 55 L. Ed 2d 82, and Royster Company, 479 F.2d 387.)

Cases Involving Tenure

In recent years, litigation has involved cases where an educational institution or system pays a teacher for retirement or for the surrender of tenure rights. Historically, the IRS has successfully challenged what is considered to be severance pay as the payment of wages subject to FICA and FUTA taxes. Cases involving the termination of educational employees or other workers who possess what are considered tenure rights have met with more uncertain results. Such cases include North Dakota State University, University of Pittsburgh, and Appoloni.

In University of Pittsburgh, the University of Pittsburgh paid amounts to certain tenured faculty to buy out their tenure rights so they would retire early. From 1996 to 2001, the university paid out more than $2 million in such buyouts. The university submitted FICA taxes with regard to the buyout payments and then sued for a refund on grounds that the amounts had been paid for surrender of tenure rights. The IRS rejected the claim, so the university brought a lawsuit in federal district court. The IRS contended that the payments were made for seniority rights. Following the precedent of North Dakota State University [255 F.3d 599 (8th Cir. 2001)] and Revenue Ruling 58-301, 1958-1 C.B. 301, the court held that payments for the surrender of tenure rights do not constitute wages.

In North Dakota State University, the Eighth Circuit held that amounts paid for relinquishment of tenure rights were not subject to FICA where the tenure rights were based upon factors other than length of service. These factors included scholarship, teaching, research, and contributions to society. As expressed by the court, “The decision to award tenure rests on criteria that reflect the potential long term contribution of the faculty member to the purposes, priorities, and resources of the institution, unit and program.” The existence of tenure at North Dakota State served as recognition of contributions that had been made to the academic world or to one’s discipline or profession, as well as a protection of academic freedom. Tenure was considered more of a protected right.

In light of the role of tenure as expressed in North Dakota State University, significant differences were found to exist between tenure rights and seniority rights:

  • Tenure is awarded to allow intellectual and academic freedom of inquiry and expression.
  • Tenure is not dependent upon length of service alone.
  • Tenure is a discretionary determination based on certain subjective criteria.
  • Tenure is a property right that is not transferable, and as such, the receipt of tenure, by itself, cannot be viewed as triggering income recognition.
  • Tenure is not amenable to being treated as restricted compensation.
  • Tenure provides certain protected rights and the ability—absent certain just cause and adherence to certain procedural protections—the right to retain one’s position absent cause or financial exigency.

In Nierotko, the IRS indicated that not all payments flowing from an employer to an employee were within the ambit of wages despite finding that amounts paid as back pay represented compensation for services amenable to FICA.

In Revenue Ruling 58-301, 1958-1 C.B. 23, the IRS indicated that payments made in retirement of a contractually guaranteed right of employment did not constitute wages. The amount was paid for the cancellation of the balance of a five-year employment contract. It was considered to be ordinary income and not capital gain, as it was not in return for a capital asset. Although includible in gross income, the amounts were not subject to FICA or federal income tax withholding.
In contrast to Revenue Ruling 58-301, Revenue Ruling 75-44, 1975-1 C.B. 15 held that amounts paid as consideration for “the employee agreeing to perform a different type of work and refrain from asserting employment rights acquired as a result of past services rendered pursuant to contract were wages, and as such subject to federal income tax withholding.” Revenue Ruling 75-44 has been distinguished from Revenue Ruling 58-301 in that 58-301 involved payment primarily for “cancellation of the employee’s original contract rights rather than primarily in consideration of the past performance of services through which the relinquished employment rights were acquired.”

In the recent case of Appoloni, Sr., et al. v. United States [No. 04-2068, 05-0149 (6th Circuit, June 7, 2006)], the Sixth Circuit adopted an expansive view of when amounts paid to teachers for the surrender of tenure rights constituted wages under IRC section 3121. The case concerned school districts that made payments to teachers who had received what was called tenure, based largely on having worked a certain number of years. As expressed by the court: “Classification of the payment and its tax treatment are determined not merely upon the label used for the right, but how the right was acquired.” The payments were largely due to the number of years worked and couldn’t be viewed as solely a tenure right, but rather for early retirement. In the court’s opinion, these payments did not vary from the type of payments classified in severance package cases. The court looked favorably on the IRS’s citation of Revenue Ruling 75-44 and took an expansive view of wages. The court noted that the motive for purchase of the rights was the same as in cases where individuals were paid to surrender employment rights, which had been held to be wages. In Appoloni, it was noted that the purchase of purported tenure rights was necessary to terminate the worker’s services.

The court left open the possibility that had the facts of the case been different, a different outcome might have been reached. In this regard, the decision was reached because the facts supported a finding that the payments made were based upon longevity (number of years of service) rather than on tenure rights, which take more fully into account different variables and provide protection for expression and inquiry (e.g., in North Dakota State University).

Noteworthy Revenue Rulings

There are several revenue rulings concerning the tax treatment of amounts received for cancellation of contract rights. Among the most recent is Revenue Ruling 2004-110, 2004-2 C.B. 960. This ruling addresses a scenario where an employee and employer had entered into a written employment agreement that lacked a provision concerning the possibility of payments if the contract were canceled by mutual agreement prior to the end of the contract period. In this case, after several years the contract was terminated by mutual agreement and the employer agreed to pay the employee an amount for cancellation of the employee’s contract rights. In its analysis, the IRS reviewed other relevant rulings and indicated that it was modifying the position it had taken in such rulings. The IRS noted that the term “wages” is broadly defined for FICA and FUTA purposes. The IRS noted that the code and regulations consider any payment made by an employer to an employee to be remuneration absent a specific exception to the contrary. The label given to this payment is irrelevant. In addition, the payment will still be considered to be remuneration even though no employer-employee relationship existed at the time of the payment. Citing IRC sections 3121(b) and 3306(c), and Regulations sections 331.3121(b)-3(b) and 31.3306(c)-2(b), the IRS noted: “Employment encompasses the establishment, maintenance, furtherance, alteration, or cancellation of the employer-employee relationship or any of the terms and conditions thereof. If the employee provides clear, separate, and adequate consideration of the employer’s payment that is not dependent upon the employer-employee relationship and its component terms and conditions, the payment is not wages for purposes of FICA, FUTA, or Federal income tax withholding.”

Based upon this fact pattern, where the employee receives the payment as consideration for the cancellation of the contract, the payment would be treated as remuneration unless there is clear evidence to the contrary. The IRS in turn stated that Revenue Rulings 55-520 and 58-301 each failed in their analyses and that the payments in those situations should have been classified as wages.

Revenue Ruling 55-520, 1955-2 C.B. 393 had found that an amount received by a worker as compromise for a claim based upon cancellation of an employment contract, although constituting income, was not wages for FICA or FUTA purposes. Likewise, Revenue Ruling 58-301, 1958-1 C.B. 23 concluded that a lump sum received by an employee for cancellation of the balance of an employment contract was includible in income but was not considered wages for FICA or FUTA purposes. According to the ruling, the amount paid was deemed to have been paid for relinquishment of contract rights.

In contrast, Revenue Ruling 74-252, 1974-1 C.B. 287 found that an amount paid to an employee for involuntary termination of a contract was wages and subject to FICA and FUTA taxes. According to the terms of the agreement, the payments were different than those in Revenue Ruling 58-301—they were considered dismissal payments under the terms of the contract rather than consideration for the relinquishment of rights under the contract. Relevant to the finding was that the contract allowed the employer to terminate the contract at any time, so long as the employee was paid an amount equal to an additional six months’ salary. Likewise, Revenue Ruling 75-44, 1975-1 C.B. 15 involved payments made in consideration of the employee doing a different type of work without raising issues concerning rights that might have been provided under a prior employment contract. The payments were found to be subject to FICA and FUTA taxes. The ruling states that it modifies and supersedes Revenue Rulings 55-520 and 58-301.

CSX

Certain courts have held that supplemental unemployment compensation benefits meeting the criteria of IRC section 3402(o) are not subject to employment taxes. For example, in the recent case of CSX Corporation, et al. v. United States [No. 95-0858T, U.S. Ct. of Federal Cl.s (2006)], the Court of Federal Claims examined whether certain payments made to employees as part of a plan to reduce CSX’s workforce were subject to employment taxes pursuant to section 3402(o).

Previously the court had ruled that “lump sum amounts given in exchange for an employee’s agreement to terminate his or her relationship with the company and to relinquish all rights and benefits associated with that relationship” would be considered supplemental unemployment compensation benefits when elected by an employee then in layoff status. In contrast, where the election to separate is made by employees in lieu of their existing positions or in lieu of standby, the amount will not qualify as supplemental unemployment compensation. In CSX, the court addressed the following two issues:

  • Whether payments made to a furloughed employee who declines to transfer and elects to accept a separation allowance rather than remain in layoff status (without benefits) can be considered paid to the employee due to involuntary separation from service.
  • Whether documentation provided by the plaintiffs established that they were on furlough status at the time they elected to separate and thus not subject to employment tax.

With regard to the first issue, the court found that an employee who has been laid off “declines the opportunity to resume his or her employment (albeit at another location) and who instead elects to separate in lieu of relinquishing all layoff benefits cannot be said to have been involuntarily separated.” The court ruled that the payment does not avoid employment taxes pursuant to IRC section 3402(o). With respect to the second issue, the court found that interoffice documentation, including a memorandum from the senior vice-president of transportation and accounting with the personal data in handwritten notes, could be considered proof that certain individuals were on furlough at the time of their separation.

Be Aware of the IRS’s Stance

Whether payments made to past or present workers are subject to employment taxes can make a significant financial difference. Recent cases such as University of Pittsburgh, Appoloni, and CSX provide insight into the issues that arise in the classification of payments associated with termination of service. In light of the IRS’s expansive view of what constitutes wages, taxpayers must be wary of how amounts paid associated with wages are classified for tax purposes. Nevertheless, by being aware of relevant statutes, cases, and IRS pronouncements, advisors can better help individuals achieve desired results.


Mark A. Segal, CPA, JD, LLM, is a professor of accounting at the Mitchell College of Business at the University of South Alabama, Mobile, Ala.


 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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