Suboptimal Tax Laws Are Still Valid Tax Laws

I have a family member who has accepted in position in, and will be moving to, Chicago. You can bet that we have discussed the compensation package, and I am to review the deferred compensation package when provided. His is a “C suite” position, so deferred compensation means more than just the 401(k) with which you and I are familiar.

I find myself reviewing a Federal Court of Claims decision on an airline pilot that got on the wrong side of FICA taxation of deferred compensation.

His name is Louis Balestra, and he was a pilot with United Airlines from 1979 until his retirement in 2004. There may have been no tax case, except that United Airlines filed for bankruptcy in 2002.

Let’s talk about the “general timing rule” for FICA taxation. It is easy: you pay FICA when you are paid. No pay, no tax. No fair to not cash your paycheck!

We also have deferred compensation, more specifically “nonqualified” deferred compensation, which means a retirement plan which deviates, either a little or a lot, from somewhat rigid IRS requirements in order to be “qualified.” There is then a ‘special timing rule” (I am not making this up, I swear), the purpose of which is to speed-up when the income is taxed for FICA. The Code section is 3121(v)(2):

   3121(v)(2) TREATMENT OF CERTAIN NONQUALIFIED DEFERRED COMPENSATION PLANS.—

3121(v)(2)(A) IN GENERAL.— Any amount deferred under a nonqualified deferred compensation plan shall be taken into account for purposes of this chapter as of the later of—

3121(v)(2)(A)(i)   when the services are performed, or

3121(v)(2)(A)(ii)   when there is no substantial risk of forfeiture of the rights to such amount.

We have a new shiny: “substantial risk of forfeiture.” If the company funds your benefit, for example, chances are that your FICA tax will be accelerated, perhaps many years before you actually receive any money.

Let’s work through this with an extremely simplified example. The company agrees to pay you $100,000 five years from now. Let’s also posit that you clear the second requirement of “no substantial risk of forfeiture.” Congratulations, you have FICA tax. Right now.

Being a tax accountant by training if not by temperament, I have to ask the question: how do I calculate the income to be taxed? Is it $100,000? That doesn’t make sense, as you will receive the money five years from now. A hundred grand then is not the same as a hundred grand now, if for no other reason than you could put it n a CD (if you received it now) and have more than a hundred grand five years hence. Is it the present value of the $100,000, discounted at some interest rate and for five years? That makes more sense, and that is the guidance provided by the Regulations.

Remember what I said about United Airlines filing for bankruptcy in 2002, two years before Balestra retired? Shouldn’t we take into consideration that United Airlines might not pay everything to which Balestra is entitled?

Makes sense to me. For example, Balestra paid FICA on approximately $289,000 of deferred compensation. United actually paid him approximately $63,000. He had paid FICA on that entire $289,000, and he wanted some of it back.

CLARIFICATION: It would be more correct to say that he paid the Medicare portion of FICA, as the social security side only applies up to an income limit.  Let’s continue. We are on a roll.

Balestra sued.  

And the Court was looking at the Shakespearean prose of Reg 31.3121(v)(2)-1(c):

(ii) Present value defined.— For purposes of this section, present value means the value as of a specified date of an amount or series of amounts due thereafter, where each amount is multiplied by the probability that the condition or conditions on which payment of the amount is contingent will be satisfied, and is discounted according to an assumed rate of interest to reflect the time value of money. For purposes of this section, the present value must be determined as of the date the amount deferred is required to be taken into account as wages under paragraph (e) of this section using actuarial assumptions and methods that are reasonable as of that date. For this purpose, a discount for the probability that an employee will die before commencement of benefit payments is permitted, but only to the extent that benefits will be forfeited upon death. In addition, the present value cannot be discounted for the probability that payments will not be made (or will be reduced) because of the unfunded status of the plan, the risk associated with any deemed or actual investment of amounts deferred under the plan, the risk that the employer, the trustee, or another party will be unwilling or unable to pay, the possibility of future plan amendments, the possibility of a future change in the law, or similar risks or contingencies.

Balestra tried, but he could not overcome the fact that the Regulations did not include “employer bankruptcy” as a possible reason to discount the amount of income accelerated for FICA tax – or, at least, to allow some of the FICA to be refunded once the actual payments are known.

Balestra lost his case.

The Court did realize the unfairness of the law, however.

It might have been wiser to have selected as a trigger something other than there being ‘no substantial risk of forfeiture’ … and instead considered the financial solvency of the employer – or to have deferred taxation while an employer is in bankruptcy, rather than until promised benefits are ‘reasonable ascertainable.”

You think?

But these are matters for law makers, not judges – suboptimal laws are still valid tax laws.”

I know. I would be more optimistic if I had any regard for the suboptimals in Congress.

Tile 26 of the United States Code would be a good deal shorter if the unwise tax laws could be purged by the judiciary.”

You must admit, it is easy to like this Court.

JPMorgan's Nondeductible Madoff Deal

On January 7, 2014, JPMorgan entered into a deferred prosecution agreement with the Justice Department. This is another payment in the ongoing Bernie Madoff saga, and the bank agreed to pay a $1.7 billion settlement as well as $350 million to the Office of the Comptroller of the Currency and $543 million to a court-appointed trustee.

Madoff kept significant balances with JPMorgan.  Banks are the first line of defense against fraud, but JPMorgan never filed suspicious activity reports with regulators, even though there were significant reservations as to when they became suspicious. The bank did not admit any criminal activity in the agreement, but it did allow that it missed red flags from the late 1990s to late 2000s.

What caught my eye was the following text from the following joint release by the Manhattan U.S. Attorney and FBI:
           

… JPMorgan agrees to pay a non-tax deductible penalty of $1.7 billion, in the form of a civil forfeiture, which the Government intends….”

This is unusual language.

The tax code provides a tax deduction for all of the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.

And then the tax Code starts taking back. One take back is Section 162(f):

162(f) FINES AND PENALTIES.— No deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law.

Let’s drill down a little bit into the Regulations:

This prohibition applies to any fines paid by a taxpayer because the taxpayer has been convicted of a crime (felony or misdemeanor) in a full criminal proceeding in an appropriate court.   The prohibition also extends to civil fines if the fines are intended by Congress as punitive in nature.

So, if fines are paid pursuant to a criminal case, then the taxpayer is hosed. However, if fines are paid pursuant to a civil case, there is one more step: are the fines punitive in nature?

Attorneys differentiate damages between those that are remedial and those that are punitive. A remedial payment is intended to compensate the government or another party – to “make one whole,” if you will. It is intended to restore what was disturbed, upset or lost, and not intended as penalty or lashing against the payer.

Let’s complicate it bit. There is a court case (Talley Industries Inc v Commissioner) that allows damages to be deductible if they are remedial in intent, even if labeled as a fine or penalty.

EXAMPLE: The NFL fines a player for unnecessary roughness. The NFL can call this a fine, but it is not a fine per Section 162(f) and will be deductible to the player involved.

You are seeing how this is fertile hunting ground for tax lawyers. Unless the payment is pursuant to a criminal case, odds are good that it is deductible.

Now remember that this agreement is Madoff related, and that there are hard feelings about JPMorgan’s involvement with Madoff over the years, and you can see why the Justice Department included the “nondeductible” language in the agreement.

Let’s take this a step further. Under Talley, JPMorgan could deduct the $1.7 billion on its tax return. Remember, it is not a fine or penalty under Sec 162(f) just because somebody somewhere called it as such.

Would JPMorgan be likely to do this?

This is a “deferred prosecution” agreement.  If JPMorgan did deduct the settlement, they might not have an issue with the IRS, but they would likely have a very sizeable issue with the Justice Department.