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In its recent decision in University of Pittsburgh v. United States, the 3rd U.S. Circuit Court of Appeals held that early retirement payments made by the University of Pittsburgh to tenured faculty members constitute “wages” and are therefore taxable as ordinary income and subject to federal employment taxes.

The 3rd Circuit’s decision is consistent with the decision of the 6th Circuit in Appoloni v. United States, which held that early retirement payments made to tenured public school teachers also constituted wages for federal employment tax purposes. In an earlier decision, the 8th Circuit took a contrary position in North Dakota State University v. United States, holding that a university’s early retirement payments to tenured faculty members were made in exchange for the relinquishment of contractual rights, not as remuneration for services, and were therefore not wages subject to federal employment taxes.

Between 1982 and 1999, the University of Pittsburgh offered a series of early retirement plans to both tenured faculty members and nontenured librarians. Payments under all of the plans were made monthly, and were based on an employee’s salary at the time of retirement and length of service to the university. In all of the plans, participation was limited to covered employees who met both minimum age and length of service requirements. To participate in a plan, employees who had tenure were required to relinquish their tenure rights. Pursuant to university policy, employees with tenure were essentially guaranteed continued employment with immunity from termination except for cause or financial exigency.

All of the circuit courts agree that payments received in exchange for the relinquishment of contractual rights to future employment constitute ordinary income and not capital gains taxed at a more preferential, i.e., lower, rate (ordinary income is currently taxed at a maximum rate of 35 percent while long-term capital gains are generally taxed at a maximum rate of 15 percent). The courts agree that contractual rights to future employment do not constitute a “capital asset,” the sale or exchange of which is necessary for the realization of a capital gain.

The singular issue of disagreement among the circuits is whether the ordinary income realized upon the relinquishment of contractual rights to future employment (including the rights of tenured faculty) constitutes “wages” for federal employment tax and income tax withholding purposes. In essence, the 8th Circuit takes the position that such payments relate exclusively to the relinquishment of a property right, regardless of how that property right accrued, while the 3rd and 6th circuits have concluded that such payments are inherently the product of an employment relationship and therefore constitute wages.

Sections 3101 and 3111 of the Internal Revenue Code impose taxes under the Federal Insurance Contributions Act (FICA) on “wages” earned with respect to “employment.” FICA taxes consist of the Old-Age, Survivors and Disability Insurance Tax (Social Security tax) and the Hospital Insurance tax (Medicare tax). These taxes are imposed on both the employer and employee. In addition, Code sections 3301 and 3306(b) impose an additional tax on wages under the Federal Unemployment Tax Act (FUTA). The FUTA tax provisions are similar to the FICA provisions, except that only the employer pays the tax imposed under FUTA.

The term “wages” is defined for FICA purposes in Code Section 3121(a) as all remuneration from employment, with certain specific exceptions. Code Section 3121(b) defines “employment” as any service, of whatever nature, performed by an employee for the person employing him, with certain exceptions. The pertinent employment tax regulations further provide that in determining whether a payment constitutes “wages,” the name by which the remuneration is designated is immaterial as is basis upon which the remuneration is paid or calculated.

The 3rd Circuit in University of Pittsburgh identified several factors that led to its conclusion that the payments by the university to its tenured faculty members constituted wages. First, the court noted that the eligibility requirements for payments under the early retirement plans were directly linked to past services at the university and not to the relinquishment of tenure rights. Specifically, the court noted that the early retirement plans were offered to both tenured and nontenured employees and the only criteria for eligibility were the employees’ ages and years of service.

Next, the court cited the language of the early retirement plans themselves as evidence that the payments were viewed by the university as compensation for services

rendered. The court cited a provision in one plan that stated that the purpose of the plan was to provide faculty members with maximum flexibility and opportunities in planning for their retirement.

Similarly, the court concluded that even if the university made the payments in part to secure relinquishment of tenure rights, their main purpose was to provide for the employee’s early retirement. Accordingly, the court stated that such payments were indistinguishable from severance payments, which are generally taxed as wages.

The taxpayers in University of Pittsburgh, who were successful at the district court level (in a decision rendered by a magistrate judge), relied upon an argument initially adopted by the IRS in Revenue Ruling 58-301, that a lump sum payment received by an employee as consideration for his agreement to cancel the remaining term of an employment agreement constitutes ordinary income arising from the relinquishment of a contractual right and not wages subject to FICA or FUTA.

This is also essentially the basis for the 8th Circuit’s decision in North Dakota State University. However, both the 3rd Circuit and the 6th Circuit (in Appoloni) concluded that the tenure rights at issue were earned through service to the employer and any payments received upon relinquishment of such rights were remuneration arising from employment and are taxable as wages subject to FICA and FUTA.

The decisions of the 3rd Circuit and the 6th Circuit are also consistent with more recent rulings of the IRS, which supersede Revenue Ruling 58-301. In Revenue Ruling 2004-110, the IRS held that amounts paid to an employee upon the early termination of a written employment contract providing for a specified number of years of employment constituted wages for purposes of FICA and FUTA. The IRS specifically stated that the payments were entirely dependent upon the employer-employee relationship and must be characterized as wages. This ruling simply states that Revenue Ruling 58-301 “erred” in its analysis.

The term “wages” for FICA and FUTA purposes is expansively defined to include virtually any payment arising from an employment relationship. Based upon this statutory framework, it appears that the 3rd and 6th circuits have correctly concluded that payments made in relinquishment of future rights to employment constitute “wages” subject to FICA and FUTA. •

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