Early Retirement Payments Are Taxable, Court Rules

Federal appeals panel orders Pitt to pay $2.2 million in Social Security taxes, deeming professors' tenure to be just another right based on past service to university.
November 5, 2007

Federal courts can't seem to decide whether early retirement payments to faculty members should be taxed as compensation -- and the issue may well be on its way to the U.S. Supreme Court.

A divided three-judge panel of the U.S. Court of Appeals for the Third Circuit ruled Friday that such payments should be subject to Social Security taxes even if the profesors relinquished their rights to tenure as part of the early retirement deal. Friday's ruling, in a case that pitted the University of Pittsburgh against the Internal Revenue Service, is the third such case to be decided by a federal appeals court this decade, and reveals a clear rift among the circuits.

In 2001, the U.S. Court of Appeals for the Eighth Circuit in 2001 declared that payments made to tenured professors who participated in an early retirement program at North Dakota State University should not be considered “wages” under the Federal Insurance Contributions Act, which governs Social Security.

But last summer, the U.S. Court of Appeals for the Sixth Circuit, in a case involving Michigan high school teachers, concluded that the fact that instructors qualified for payments under an early retirement program based on their years of service indicated that the payments were for services performed rather than for the relinquishment of tenure rights. That and other factors led the court to rule that the “tenure rights at issue were earned through service to the employer…. [W]e see no reason to differentiate tenure rights from any other right an employee earns through service to any employer.”

The issue is an important one for colleges and universities, many of which offer early retirement incentives to faculty members, sometimes to cut budgets (by replacing higher paid senior professors with lower-paid junior or part-time ones) and sometimes to free up slots for instructors in emerging fields.

The case decided Friday involved payments the University of Pittsburgh had made to administrators, faculty members and non-tenured librarians in five early retirement programs between 1982 and 1999.

In 2001, the university sought a refund of $2.2 million from the IRS for Social Security taxes it had made on the payments to tenured faculty members, which Pitt officials said were "buyouts" of their rights to tenure rather than merely wages. The IRS declined the refund, Pitt sued, and in November 2005, a federal judge sided with the university, ordering the IRS to repay about $2.1 million plus statutory interest. The federal government appealed to the Third Circuit.

In their ruling Friday, two of the three members of the appeals panel acknowledged the division in the previous rulings by other appeals courts and cited similar discord in various IRS "revenue rulings" cited by the agency and by Pitt.

The majority cites several key features about the early retirement plans offered to Pitt faculty members. Retirees were rewarded primarily based on their age and years of service, which "link the plan payments to past services for the employer." The university offered the plans in part to make room for new faculty and in part "to provide maximum flexibility and opportunities for its faculty members to retire voluntarily prior to the mandatory retirement age." And the payments were much like severance payments (which are taxable), the court argued, because "their main purpose was to provide for employees' early retirement."

Taken together, the majority concluded, "the record in this case shows that payments under the plans were primarily in consideration for employees' past service to the university. Relinquishment of tenure rights, while a condition precedent to the payments, was not the primary consideration that employees offered. The payments therefore qualify as wages subject to FICA taxation."

The dissenting judge, Anthony J. Scirica, sought to distinguish the awarding of tenure from other kinds of "seniority rights" that professors or other employees might earn over time. "Tenure is more than a recognition of satisfactory work," Scirica wrote, because "the decision to grant or deny tenure depends on myriad qualitative factors and calls for an evaluation of each candidate's capacity for research, teaching and contributing to knowledge."

In addition, the judge wrote, the awarding of tenure "marks a new relationship between professor and university," ensuring academic freedom and changing the grounds on which a faculty member can be dismissed. So payments under an early retirement program that ends that relationship, Scirica argued, "are more analogous to buyouts of unexpired contract rights than to severance payments or payments for the relinquishment of rights of at-will employees." So they should not be taxed as remuneration for employment, he said.

Pitt officials said Sunday that a decision about whether to appeal the Third Circuit's ruling was "under review": "The university will not make its determination until it has had an opportunity to review in detail the majority opinion and Chief Judge Scirica’s dissent and therefore will not have comment at this time."


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