When are wages not FICA wages?

Any 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 lumpsum 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.