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Taxpayers should never be taxed on income they don’t receive. But it happens. It occurred in a recent decision, Koopmann v. United States, No. 09-CV-333 T (Fed. Cl. Sept. 30, 2020), and there are lessons that may be learned from what went wrong for the litigant in that case.
In Koopmann, the taxpayer retired from United Airlines in 2000, and was covered by United Airlines' non-qualified deferred compensation plan. About two years after the taxpayer’s retirement, United Airlines filed a Chapter 11 bankruptcy petition, which ultimately resulted in an approved reorganization plan in 2006. As part of the reorganization plan, United Airlines' obligation to pay the taxpayer’s deferred compensation was discharged. The taxpayer had received a portion of his deferred compensation from 2001 through the 2006 date of discharge, however a substantial portion of the deferred compensation was never paid the taxpayer.
The tax rub in this scenario is that notwithstanding the deferred nature of the compensation, there is a special timing rule under which taxpayers still pay FICA on compensation they receive under a non-qualified deferred compensation plan. Under the “special timing rule” FICA tax is assessed only once, at the later of either: (A) the date services are performed or (B) the date when there is no substantial risk of forfeiture of the rights to such amount. See 26 C.F.R. § 31.3121(v)(2)-1.
For the taxpayer in Koopmann, he paid FICA taxes on $415,025.91 worth of non-qualified deferred compensation at the time of his retirement, but prior to the discharge had received only $248,293, spread out from 2001 - 2006. If there had been signs of a bankruptcy at the time of his retirement, the taxpayer might have taken the position that it was premature to pay FICA taxes due to an exigent or impending risk of forfeiture, but presumably the taxpayer had not reached that conclusion. In any event, by 2006 when the deferred compensation was discharged, the 3-year statute of limitations in Section 6511 had, on its face, long expired for claiming tax payments for returns filed in 2001. In an attempt to overcome this statute of limitations problem, the taxpayer advances several legal theories.
Koopmann’s main argument hinged on the Fifth Amendment – specifically, that it would violate the Due Process Clause to bar a refund on statute of limitations grounds when the purported eligibility for that refund --- the discharge of United Airlines' obligation to make payments towards his non-qualified retirement benefits --- did not occur until after the statute of limitations had run. The argument has initial appeal, however those versed in Constitutional law may appreciate this row is likely too long to hoe. The court made short work of it. The court similarly dispensed with theories such as equitable tolling (reasons at equity for pausing or extending the statute), the discovery rule (delaying the statute’s start until the party subject to the statute knows a claim has accrued), and the validity of the Section 3121 regs. Equitable tolling arguments pose particular challenge in the face of Supreme Court jurisprudence including edict in United States v. Brockamp, 519 U.S. 347 (1997). In the Internal Revenue Service Restructuring and Reform Act of 1998, Congress provided some relief from Brockamp but still there is little room to argue for equitable-type tolling principles. Each of the other arguments raised by Koopmann had been rejected in other court cases, and were likely futile under Federal Circuit precedent.
In future cases, taxpayers and their advisors might explore different approaches that do not depend on arguments that may be viewed as asking courts to re-write the statute of limitations in Section 6511, or Constitutional arguments which, in Federal tax cases, courts take seriously in very narrow sets of circumstances. Foremost, filing protective refund claims as soon as there’s any sign of a bankruptcy or other substantial risk of forfeiture should be considered as a way to preserve the taxpayer’s right to a refund. There also may be more promising legal theories that do not require overcoming the statute of limitations. For example, in the year of the discharge, taxpayers might consider claiming a bad debt deduction under Section 166, with the excess taxes paid as the deductible basis. There also may be room to argue that under the special timing rule the FICA remitted should be treated as a deposit. Seeking a legislative fix may also be appropriate given the harsh inequities of paying tax on amounts never received and the absence of a clear path to remedy the inequities.
Given the ongoing struggle to contain the Covid pandemic, and fully open the economy, it would not be surprising to continue to see the rate of bankruptcies climb. With this trajectory, Koopmann is unlikely to be the last victim to paying FICA on deferred compensation that is discharged in bankruptcy. Potentially affected taxpayers and their advisors should consider proactive measures and remedial actions to avert the fate of Koopmann and others before him.