The Court of Federal Claims concluded something all of us learned early on—“suboptimal tax laws are still valid tax laws” in upholding the taxation of deferred compensation in 2004 for a taxpayer that was clear even when included in the employee’s income would never be paid in the case of Balestra v. United States, 113 AFTR 2d ¶2014-887.
The taxpayer in this case was a pilot for an airline who retired in 2004. The airline in question entered bankruptcy in 2002. In 2004 Mr. Balestra retired from the airline.
One of the benefits promised to Mr. Balestra was a nonqualified deferred compensation payment arrangement. The benefit vested upon Mr. Balestra’s retirement. Under IRC §3121(v)(2) the airline computed the present value of the promised future benefits to be paid under the program. Based on that computation the airline withheld Medicare taxes (Mr. Balestra was over the FICA limit for 2004) on that value.
IRC §3121(v)(2) imposes a special rule for FICA and Medicare taxes imposed on nonqualified deferred compensation arrangements. Under the special timing rule, the tax is imposed on such arrangements at the later of the date services are performed or when there is no substantial forfeiture of rights to the amount.
Under the regulations implementing this provision (Reg. §31.3121(v)(2)‑1) that value is computed without regard to the possibility that the payments may not be made due to the fact that the plan is not currently funded, the employer may be unable to pay or there may be a future change in the law. Rather, this is a straight actuarial calculation of present value.
Using that methodology spelled out in the regulations, the airline computed the present value of the taxpayer’s benefit as $289,601.18 and withheld 1.45% (or $4,199.22). However, the airline was eventually relieved of the responsibility to pay most of this benefit at the end of its bankruptcy proceeding and Mr. Balestra only actually received $63,032.09 of benefits through 2010, with no additional benefits to be received under the program in the future.
The taxpayer, not surprisingly, felt this was unfair, especially as the airline was already in (and had been in for two years) the bankruptcy proceeding that would lead to the reduction of the benefit when Mr. Balestra retired. It certainly did not take much foresight to conclude Mr. Balestra was highly unlikely to receive $289,601.18 of benefits, whether or not the benefits were to be discounted to present value.
However, the IRS argued that the regulations properly required the payment of the tax on the total benefit. The Court, noting that the question before it was simply whether the IRS’s regulation was a reasonable interpretation of the statute found that it was.
The taxpayer argued first that the amount should not be considered taxable until paid. The Court rejected that view, noting that if it adopted that reading of the statute that §3121(v)(2) would be rendered meaningless, since tax would always be imposed at the same time as under the standard timing rules for FICA and Medicare tax obligations. Generally, when comparing alternative interpretations of a statute, the Court will avoid an interpretation that renders the provision irrelevant unless it is clearly required by the unambiguous language of the state.
The Court also noted that the language used by Congress (that the tax is triggered “when there is no substantial risk of forfeiture of the rights to such amount”) uses terms given specific meaning by IRC §83(c)(1) and which, by itself, contains no reference to a risk of nonpayment. While that statute was specifically limited to property actually received, Congress included no such restriction in §3121(v)(2).
The taxpayer argued secondly that Congress must have meant to include “standard accrual accounting” and argued that since it was clear there was a significant question with regard to payment of the vast majority of the benefit, the amount taxed should have been reduced that uncertainly. However, the Court refused to effectively “add” to the statute such an implied reference, noting that Congress has explicitly included such references in other statutes but chose not to do so here.
The Court note that, under the standard imposed by the U.S. Supreme Court in the case of Mayo Found. for Med. Educ. & Research v. United States, 131 S. Ct. 704, a regulation interpreting a ambiguous provision of the statute must be upheld if it is reasonable. The Court found, given its analysis, that the IRS’s interpretation was a reasonable one for what might be charitably called a “flawed” statute.
The Court took a dig at Congress by noting, after considering alternatives that Congress arguably should have used:
But these are matters for law makers, not judges—suboptimal tax laws are still valid tax laws. (Title 26 of the United States Code would be a good deal shorter if the unwise tax laws could be purged by the judiciary.)
So, at the end of the day, the Court found the IRS properly applied an unwise, suboptimal law in a reasonable fashion. And so, the taxpayer was not eligible for a refund of Medicare taxes imposed on a benefit he will never receive.
The taxpayer sought relief from the Federal Circuit Court of Appeals, but was denied relief there as well. The Court of Appeals also agreed that the IRS interpretation represented a reasonable method for dealing with the matter at hand.