FICA Tax on Early Retirement Incentives Paid to Faculty: Benefits Briefs. Vol. 13, No. 2

FICA tax is imposed on “wages”” paid by an employer to an employee. It is well established that severance pay, dismissal pay, golden parachute pay and similar payments are considered wages subject to FICA. In a case that every retired professor in North America seems to have read, a federal district court in North Dakota has held that FICA is not due on early retirement incentives paid to tenured faculty members. North Dakota State University v. United States, 1999 U.S. Dist. LEXIS 20524 (D.C.N.D. 11/19/99). The university designed an early retirement incentive that would pay up to one year’s pay to any faculty member or high level administrator who elected to retire. The precise level of the benefit was left to be negotiated between the employee and the employee’s supervisor. In exchange for this benefit the recipient had to agree to retire, not to seek future employment in the North Dakota University system, execute a release and, in the case of faculty, give up tenure rights. When the Social Security Administration told the university that these payments did not constitute “wages” for benefits purposes (i.e., their receipt would not reduce the otherwise payable Social Security benefits of the retiree) the university adopted the wages is wages is wages rule to justify no longer paying FICA taxes. This lawsuit followed.

The court held that the payments to faculty were not “wages,” not because of the Social Security treatment, but because the payments were not in the nature of compensation for services. Instead, the court decided, they were made for the purpose of buying out faculty contract rights, i.e., the tenure contract with the university. At the same time, the court held that the very same benefits paid to university administrators were wages because they were at-will employees who had no tenure to relinquish. This decision was based on an IRS ruling from the fifties in which the Service held that a payment for the buyout of an employment contract was not wages. As one might expect, the IRS is not happy with this decision. Its later rulings have not adopted the reasoning of the fifties ruling and a 1997 Technical Advice Memo on all fours with this case expressly stated that payments to terminated faculty members were wages. Tech. Adv. Mem. 9711001, 1995 PRL LEXIS 2321 (1/23/95). The Service has naturally appealed the North Dakota case.

It is a little reckless to predict how the appeal will turn out, but we believe the IRS is likely to prevail. Its position is one of longstanding, consistently applied. Moreover, no one disputes that as a general principle severance pay is subject to FICA. The profs won in the district court solely on the grounds that unlike other workers they had to give up tenure. This seems like an unlikely distinction on which to exempt from tax one group but not another. After all, the university administrators received identical payments under an identical plan as the profs and they too had to give up valuable rights to sever employment. True, they didn’t have to surrender tenure but they did have to give up the right to future employment in a position that may well have had as much practical job security as the profs’ positions.

The situation raises, however, a genuine policy issue of whether early retirement benefits for anyone should be subject to FICA. This tax is a real irritant to retirees. At the very time when their earning power is diminished, paying FICA on top of regular income tax greatly diminishes their net pay. Moreover, other types of retirement income generally escape FICA. For example, by law, retirement benefits from all types of qualified plans, including 401(a) and 403(b) plans, are exempt from FICA. In addition, although non-qualified deferred compensation pay (top hat and SERP plans, for example) is theoretically subject to tax, it is taxed when the benefits vest, which is generally during active employment when participants are already over the Social Security wage base and hence never pay FICA tax, either at vesting or at the time of payment. Accordingly it is only early retirement incentives that get hit with FICA while other retirement benefits escape tax, a policy that seems to have little going for it.

What to do? We wouldn’t stop collecting and paying over FICA tax on any benefits you pay to tenured faculty before the appellate court reaches its decision. The chances of the court adopting the IRS position seem good, and if we are right you will have a difficult time going back to the faculty and having them pay the taxes after the fact. Similarly, we would not seek an IRS ruling because the Service will only send you back an unfavorable one. The best we can offer is to continue paying FICA but file a protective refund claim. Then, if we are wrong about the court’s likely decision, you will at least be able to get your money back for all time periods still open. In addition, you might work on your congressman to get early retirement benefits exempt from FICA. While the projected Social Security deficits used to make such a recommendation about as useful as jousting with windmills, in today’s budget surplus euphoria it’s possible Congress could be more receptive.