Tax Court Says Payments for Resigning Tenure are Taxed as Ordinary Income

Sep 25th 2019
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These are troublesome times for many small private colleges. In recent years, there have been a spate of closures caused by financial problems.

What’s ahead? More schools are likely to cease operations or merge with other schools.

High-profile shutdowns include the closure of Burlington College, which was once headed by Jane Sanders, the wife of Vermont Senator Bernie Sanders.

When colleges close, students have to find new schools, and employees have to find new jobs or retire.

Employees with tenured teaching positions shouldn’t focus all of their attention on job hunting. They also need to consider income taxes. Some financially troubled schools offer payments to those who agree to resign from their tenured positions from which they can be discharged only under extraordinary circumstances.

A tenured teacher I’ll call Dolores contacted me. She works for a college that’s unlikely to survive. Her school recently disclosed its plans to offer tenured faculty substantial payments now in exchange for their agreements to terminate their contractual rights to receive future salaries.

Dolores’s fellow academics told her to pose a straightforward question. Simply put, they want my forecast on their prospects for prevailing in the event that they submit 1040 forms that report their termination payments as lower-taxed long-term capital gains, rather than as higher-taxed ordinary income. I cautioned them not to pursue a dubious strategy.

The hitch is a 1984 Tax Court decision. (Foote, 81 TC No. 57) It says the IRS correctly requires Dolores and other professors to report their termination payments as ordinary income, the same as they’ve always had to do for their salaries.

The court ruled against Merrill J. Foote, an assistant professor of management science at Southern Methodist University School of Business Administration. The taxpayer agreed to resign from his tenured position at SMU in exchange for a payment of $46,000 that he received over a two-year period.

He reported SMU’s settlement payment as a long-term capital gain. The IRS said it was ordinary income. So did the Tax Court.

The court was unreceptive to Merrill’s explanation that tenure provides him and other SMU faculty members the opportunity to generate income from their outside activities. By aggressively exploiting the business potential of their tenures, they’re able to produce income and capital appreciation far in excess of their teaching salaries.

Therefore, he reasoned, when SMU’s faculty members enter into settlement agreements, they agree to sell intangible capital assets. The payments they receive reflect the value of their tenures as capital assets, rather than the value of their rights to receive future salaries.

While the court acknowledged that his contentions were well reasoned, it agreed with the IRS that Merrill should’ve reported the $46,000 as ordinary income.

The court precisely spelled out why the IRS prevailed. Merrill didn’t have a “capital asset” or make a “sale,” both of which are prerequisites for capital gain treatment (Code Sections 1221 and 1222).

Nor did he transfer his tenure to SMU. All he did was enter into an agreement that ended his tenure there.

Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 300 and counting).

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