In an appeal from a district court, the Third Circuit held that payments under several early retirement plans made by a university to former tenured faculty members were compensation for services subject to the FICA tax.
Background
Between 1982 and 1999, the University of Pittsburgh (the university) offered five successive early retirement plans (the plans) to tenured faculty members and administrators, as well as to nontenured librarians whose contracts provided an “expectation of continued employment.” Payments under all five plans were made monthly and were based on an employee’s salary at the time of retirement and his or her length of service to the university. To participate, employees were required to execute an irrevocable contract for participation, and employees who held tenure were required to relinquish their tenure rights.
Under university policy, tenure constitutes recognition by the university that a person so identified is qualified by achievements and contributions to knowledge to be ranked among the most worthy of the faculty members engaged in scholarly endeavors: research, teaching, professional training, or creative intellectual activities of other kinds. A nontenured faculty member can serve without tenure at the university for a maximum of seven years. After seven years, a faculty member can be terminated for failing to meet the requirements for tenure or can be granted tenure at the discretion of the university.
The university paid over $2 million in FICA taxes on payments under the plans between 1996 and 2001. In 2001, the university filed claims with the IRS for itself and on behalf of the plan participants for refunds of the total amount of the university’s FICA tax payments since 1996.
The IRS denied the refund request, and the university filed a refund suit in district court (University of Pittsburgh, W.D. Pa., 11/21/2005). The parties filed cross-motions for summary judgment. The district court granted the university summary judgment for plan payments to tenured employees, holding that those payments were “made in exchange for the relinquishment of contractual and constitutionally-protected tenure rights rather than as remuneration for services to the University” and were not subject to FICA. However, it granted the government summary judgment for the plan payments to nontenured librarians, holding that those payments were compensation for services that were subject to FICA. The IRS appealed the decision on the tenured employees.
IRS Guidance
The IRS has issued a number of revenue rulings that address whether a payment made to a departing employee is a payment for the relinquishment of contract rights (not subject to FICA as a sale of a property right) or a payment for services provided (subject to FICA as wages). In Rev. Rul. 58-301, an employer and an employee entered a five-year employment contract, which both parties agreed to cancel in the second year. In consideration of the employee’s relinquishment of his contract rights—which had been negotiated at the outset of the employment relationship—the employer paid the employee a lump sum. The Service held that “a lump sum payment received by an employee as consideration for the cancellation of his employment contract . . . is not subject to the [FICA] tax.”
Subsequent revenue rulings have distinguished and limited the applicability of Rev. Rul. 58-301. Rev. Rul. 74-252 involved a three-year contract providing that the employer could terminate the employee during the term of the contract if it paid the employee an amount equal to six months’ salary. The employer terminated the contract before it expired and paid the required sum under the contract in monthly payments. The IRS ruled that these were “dismissal payments” that were “made pursuant to the provisions of the contract rather than as consideration for the relinquishment of [property] interests” and therefore were wages subject to FICA. The Service distinguished Rev. Rul. 58-301 as involving “consideration for the cancellation of the employment contract” rather than dismissal payments provided for as part of the employment contract.
In Rev. Rul. 75-44, a railroad employee received a lump-sum payment as consideration for relinquishing seniority rights that he earned under his employment contract. The employee acquired the rights, including the right to security in his employment, based on longevity, but he remained an “at will” employee. The IRS determined that the lump-sum payment constituted taxable wages because the employee had earned the rights he was relinquishing through his previous performance of services. It distinguished Rev. Rul. 58-301 by noting that the lump-sum payment was primarily in consideration of the 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 Rev. Rul. 2004-110, the IRS ruled that payments to an employee for cancellation of the employment contract and relinquishment of contract rights are wages subject to FICA taxes. According to the revenue ruling, a payment is subject to FICA unless the employee provides clear, separate, and adequate consideration for the employer’s payment that is not dependent on the employer-employee relationship and its component terms and conditions. In the case described in the revenue ruling, the employee received the payment as consideration for canceling the remaining period of his employment contract and relinquishing his contract rights; as such, the payment was part of the compensation the employer paid to the employee.
Case Law
The two appellate courts that have previously considered the issue of payments under early retirement programs to former tenured faculty members have come to different conclusions. In North Dakota State Univ., 255 F3d 599 (8th Cir. 2001), the Eighth Circuit held that early retirement payments to faculty who were required to relinquish their tenure rights were not wages under FICA. The court determined that in that case the university’s early retirement payments were made “in exchange for the relinquishment of [the faculty’s] contractual and constitutionally-protected tenure rights rather than as remuneration for services to [the University].”
The Sixth Circuit declined to follow the Eighth Circuit in Appoloni, 450 F3d 185 (6th Cir. 2006), which involved early retirement payments to public school teachers who were required to relinquish statutory tenure rights to participate in the plan. The court found that the tenure rights at issue were indistinguishable from other types of rights earned through service (such as seniority rights or rights to bring suit) that courts have held to be wages subject to FICA. The court further found the fact that the rights were earned through service and were not contracted for at the time of employment suggested that Rev. Rul. 75-44 was more on point than Rev. Rul. 58-301.
In its decision, the court also emphasized the importance of the school district’s principal purpose in offering the severance payments. It found that the school district’s purpose was not to “buy” tenure rights but to induce faculty at the highest pay scales to voluntarily retire early. According to the court, relinquishment of tenure rights was incidental to the acceptance of the severance payment, evidenced by the fact that the school district could not offer an early retirement payment and permit the teacher to keep his or her tenure and remain employed.
Third Circuit’s Opinion
The Third Circuit sided with the Sixth Circuit and held that the payments under the University of Pittsburgh’s early retirement plans were subject to FICA. Following the same line of reasoning as the Sixth Circuit in Appoloni, the court gave four main reasons for its conclusion:
1. The eligibility requirements for payments under the plans were linked to past services at the university. The court found that eligibility for the plans was based on employees’ age and years of service, not the rights they relinquished by participating.
2. The payments were viewed as compensation for service to the university. According to the court, this was clear from looking at various statements included in the plans themselves.
3. Even if the university made the payments in part to secure relinquishment of tenure rights, their main purpose was to provide for employees’ early retirement. The court found that the early retirement payments were essentially severance payments and that the tenure rights were no different than any other rights (e.g., seniority rights) gained in the course of employment. Citing Appoloni, the court further stated that severance payments paid for the relinquishment of rights gained in the course of employment had been held in numerous cases to be compensation for past services and treated as wages subject to FICA.
4. Although awarding tenure was wholly discretionary and afforded new rights to the faculty members who received it, it was not the start of a new employment relationship analogous to the five-year employment contract in Rev. Rul. 58-301. Because the tenure period was a continuation of a faculty member’s existing employment, the court maintained that the tenure rights were earned through services performed, like the seniority rights given up by the employee in Rev. Rul. 75-44 and unlike the contract rights given up by the employee in Rev. Rul. 58-301.
For these reasons, the court concluded that payments to tenured faculty members under the early retirement plans were compensation for services and were therefore wages subject to FICA.
Reflections
As the opinion in North Dakota State Univ. and the dissenting opinions in Appoloni and University of Pittsburgh demonstrate, a reasonable argument can be made that tenure is a property right distinguishable from other rights earned over an employee’s time of service in cases in which tenure is not granted automatically at the end of a certain period of service. However, in both North Dakota State Univ. and University of Pittsburgh, the plans in question offered early retirement on essentially the same terms to both tenured and nontenured employees, belying the argument that the early retirement payments were made in exchange for the relinquishment of tenure rights. Based on the Third Circuit’s professed reasons for treating the payments as wages, the university would have had a much stronger argument if it had simply drawn up a separate plan for tenured employees specifying that the payments were made to secure the relinquishment of the faculty members’ tenure rights.
University of Pittsburgh, 3d Cir., 11/2/2007
The reports of cases, rulings, etc., herein, except for the Reflections, are edited versions of the relevant court opinion, published ruling, etc.
