Retired tenured professors' early retirement plan compensation subject to Federal Insurance Contributions Act taxation.

• Author: Kasollja, Redi
• Position: Tenured professors' early retirement plan compensation

Retired Tenured Professors' Early Retirement Plan Compensation Subject to Federal Insurance Contributions Act Taxation--University of Pittsburgh v. United States, 507 F.3d 165 (3d Cir. 2007)

The Federal Insurance Contributions Act (FICA) funds a national system of old age, survivors, disability, and hospital insurance, commonly known as social security and Medicare. (1) To achieve its purpose, FICA imposes a tax on both employers and employees at a level corresponding to a percentage of the employee's wages. (2) In University of Pittsburgh v. United States, (3) the United States Court of Appeals for the Third Circuit considered whether the payments of the University of Pittsburgh (University) pursuant to an early retirement plan (ERP) for its tenured professors constitute taxable "wages" under FICA. (4) The Third Circuit held that FICA taxation applies to ERPs because such benefits are compensation for services and thus constitute wages. (5)

From 1989 and 1999, the University implemented early retirement plans for the benefit of tenured professors and members of the administration. (6) The ERPs enabled the University to offer competitive compensation packages to new faculty and provide flexible retirement options to its existing faculty. (7) Under these plans, the University would compensate participants who chose early retirement with an amount correlating to the participant's salary at retirement and length of service to the institution. (8) As a condition of receiving this compensation, the University required all faculty participants to relinquish their tenure rights. (9) Tenure immunized faculty from termination without cause. (10)

From 1996 to 2001, the University paid more than $2 million in taxes on ERP payments to its tenured faculty.11 In 2001, the University requested a full refund; the Internal Revenue Service (IRS) denied the request. (12) In October 2004, the University responded by filing suit against the IRS in the United States District Court for the Western District of Pennsylvania. (13) The district court granted the University's motion for summary judgment, concluding that the payments it made pursuant to the ERPs did not constitute wages and therefore were not subject to FICA taxation. (14) The district court ordered the IRS to refund $2,088,358 to the University. (15) On appeal by the government, the Third Circuit reversed, holding ERP payments that require relinquishment of tenure status constitute wages under FICA. (16)

Congress intended that FICA taxation apply to a wide range of payments arising from the employment relationship. (17) The financial backbone of FICA is wages, which Congress defined as "all remuneration for employment, including the cash value of all remuneration paid in any medium other than cash." (18) The Supreme Court has construed the word "employment" to encompass the "entire employer-employee relationship for which compensation is paid to the employee by the employer." (19) Although the term "wages" comprises all compensation earned while at the service of another, wages do not necessarily include all income that one secures from his employment. (20) In assessing whether certain payments constitute FICA wages, courts consider the employer's method for calculating payments, the employer's motivation in awarding the benefits, the employee's eligibility for earning the compensation, and the nature of the employment relationship giving rise to the remunerations. (21) Applying these factors, courts have interpreted wages to include back pay, early-out payments, reduction-in-force compensation, supplemental unemployment benefits, and ERISA settlement payments. (22)

In addition to judicial guidance, the IRS, through its revenue rulings, sheds light on the definition of wages as it pertains to FICA taxation. (23) In Revenue Ruling 58-301, the IRS advised that an employer's payment to an employee to secure a mutual nullification of a multi-year employment contract does not constitute wages for FICA purposes. (24) On the other hand, in subsequent Revenue Ruling 75-44, the IRS determined that employer payments are taxable as wages when offered to induce an employee to waive seniority rights earned under a general, but indefinite, employment contract. (25) The IRS distinguished Revenue Ruling 75-44 from Revenue Ruling 58-301 in that the former concerned payment for relinquishment of rights, whereas the latter involved compensation for canceling an original agreement. (26) Recently, in Revenue Ruling 2004-110, the IRS has expressly indicated that it would not follow Revenue Ruling 58-301 after January 2005 and would consider as wages those payments that an employer offers to induce an employee to relinquish his contractual rights. (27)

In recent years, a circuit split has developed on whether FICA taxation applies to payments inducing tenured college professors to retire prematurely. (28)

The two circuits that have addressed the issue rely extensively on Revenue Ruling 58-301 and 75-44, and their opposing positions center on whether tenure redemption payments represent property-right sales, placing them outside FICA's reach, or whether they constitute taxable wages. (29) In North Dakota State University v. United States, (30) the Eighth Circuit held that, like in Revenue Ruling 58-301, payments to achieve tenure redemption are not wages because they further the sale of a property interest. (31) The court resisted likening the case to Revenue Ruling 75-44 because tenure is more than an award for past services; it is primarily a new employment relationship that commences upon its granting. (32) Alternatively, the Sixth Circuit in Appoloni v. United States (33) held payments for the relinquishment of tenure privileges constitute wages because tenure is a benefit employees earn through past service, similar to the seniority rights in Revenue Ruling 75-44. (34) The court determined that the school's motivation in approving the compensation package was to induce retirement, not to buy out tenure; hence, tenure conversion was incidental to the plan, not its principal purpose, and therefore constituted wages subject to FICA. (35)

In University of Pittsburgh v. United States, the Third Circuit determined that the University's ERP payments, for which faculty participants relinquished their tenure privileges, were wages subject to FICA taxation. (36) After reviewing the current circuit split and the applicable revenue rulings, the court accepted the Sixth Circuit's view as the more reasonable interpretation. (37) First, the court reasoned that eligibility for participation in the ERPs depended heavily on the employees' years of prior service, not tenure relinquishment. (38) The court buttressed its position that the ERP payments were wages by highlighting portions of the plans wherein the University treated the payments as compensation. (39) The court also determined that the University's partial motivation in redeeming tenure rights did not outweigh the plan's principal purpose of providing early retirement opportunities. (40) Lastly, the court disagreed that Revenue Ruling 58-301 applied to this situation because, in its opinion, tenure does not mark the beginning of an entirely new employment relationship. (41)

The Third Circuit correctly held that ERP payments professors receive in exchange for tenure constitute wages to which FICA taxation applies. (42) In so concluding, the court appropriately applied the factors that courts often use in determining whether a payment for services constitutes wages. (43) First, the contested ERP payments qualified as wages because eligibility hinged on the participant's continuous employment with the University, not on the employee's ability to provide something of value to the University. (44) Second, the court rightfully reasoned that the University offered the ERPs to strengthen its recruitment by providing attractive compensation, rather than by purchasing the existing faculty's property interest in its tenure. (45) Third, the court justly pointed out that the University calculated ERP payments, which were also...