Revenue Ruling 71-26 and Railroad Employee Taxes

Revenue Ruling 71-26 is guidance from the Internal Revenue Service that addresses the tax status of specific payments made to railroad employees. The ruling establishes that when a railroad employer makes a payment to an employee solely for that employee to give up their rights to future reemployment, the payment is not “compensation” under the Railroad Retirement Tax Act (RRTA). This distinction means the payment is treated as ordinary income, subject to regular income tax rates, but is not subject to the special payroll taxes that fund the railroad retirement system.

This classification affects both the employee and the employer. For the employee, no RRTA taxes are withheld from the payment. For the employer, the obligation to pay their portion of RRTA taxes on that amount is removed. The ruling applies narrowly to payments for the relinquishment of reemployment rights, distinguishing them from severance or dismissal pay, which are tied to past service and treated as taxable compensation.

Applicability of the Ruling

Revenue Ruling 71-26 applies to a specific set of circumstances involving railroad employees and their employers. The primary condition is that the individual receiving the payment must be an employee of an employer covered by the Railroad Retirement Act, which establishes a distinct retirement system for railroad workers funded by RRTA taxes.

The nature of the payment is the most definitive factor. The payment must be made exclusively in exchange for the employee relinquishing their contractual or seniority-based rights to be recalled for future employment. This differs from standard severance pay, which is often calculated based on an employee’s years of service and is intended to compensate for the loss of a job. A payment under this ruling is forward-looking, buying out the employee’s right to be considered for a future position.

To fall under the ruling, the agreement between the employer and employee must clearly document that the payment’s sole purpose is the surrender of these reemployment rights. For example, if a laid-off employee has a contractual right to be recalled if a position becomes available, a payment to eliminate that right would likely qualify. In contrast, a lump-sum payment calculated as two weeks of pay for every year of service would be considered dismissal pay for past work and would be subject to RRTA taxes.

If a payment combines elements of both, such as a single lump sum that is partially for relinquishing recall rights and partially for unused vacation time, only the portion clearly identifiable as being for the relinquishment of rights would fall under the ruling. Proper documentation is necessary to separate these amounts for tax purposes.

Tax Treatment of Payments

When a payment to a railroad employee meets the criteria of Revenue Ruling 71-26, its tax treatment is different from regular wages. The payment is classified as ordinary income, meaning it must be included in the employee’s gross income for the year it is received. It is subject to federal income tax at the employee’s applicable marginal tax rate.

The payment’s most significant consequence is its exclusion from RRTA taxes. Under the Railroad Retirement Tax Act, both employees and employers pay taxes on employee compensation to fund the railroad retirement system. These taxes are divided into Tier I, which is equivalent to Social Security, and Tier II, which funds additional pension-like benefits.

Because a payment for the relinquishment of reemployment rights is not considered “compensation,” it is not subject to either Tier I or Tier II taxes. This provides a direct financial benefit to both the employee, who avoids having RRTA taxes withheld, and the employer, who is not required to pay the corresponding employer share of RRTA taxes.

While the payment escapes federal employment taxes, it is generally still subject to state and local income taxes. Most states use federal adjusted gross income as the starting point for calculating state income tax liability. The payment under Revenue Ruling 71-26 is included in federal gross income and typically flows through to the state tax return.

Employer Reporting Obligations

An employer making a payment that falls under Revenue Ruling 71-26 has specific reporting responsibilities. The correct method for reporting this type of income is on Form 1099-MISC, Miscellaneous Information. The amount should be entered in Box 3, which is designated for “Other income.”

It is incorrect for an employer to include a payment for the relinquishment of reemployment rights on an employee’s Form W-2, Wage and Tax Statement. Including the payment on a W-2 would incorrectly classify it as compensation, leading to the improper withholding of RRTA taxes and an overstatement of the employee’s wages.

Because the payment is not classified as wages, it is not subject to mandatory federal income tax withholding. An exception to this rule involves backup withholding. If the employee fails to provide a correct Taxpayer Identification Number (TIN), such as a Social Security Number, the payment may become subject to backup withholding at a flat percentage rate.

Correcting Improper Reporting

If an employer incorrectly includes a payment for the relinquishment of rights on an employee’s Form W-2, the employee should first contact the employer. The employee should reach out to the payroll or human resources department to request a corrected form. The proper correction involves the employer issuing a Form W-2c, Corrected Wage and Tax Statement, which would remove the payment amount, and separately issuing a Form 1099-MISC for the same amount.

Should the employer refuse to make the correction, the employee can still report the income correctly on their tax return. The employee must report the full wage amount shown on the Form W-2 on their Form 1040. Then, an adjustment is made on Schedule 1 (Form 1040), Additional Income and Adjustments to Income.

The employee would report the amount as a negative number on the line for “Other income” and include a description such as “Non-wage payment per Rev. Rul. 71-26 reported in error on W-2.” This process ensures the income is properly reclassified as ordinary income rather than wages.

If RRTA taxes were incorrectly withheld from the payment and the employer will not provide a refund, the employee can file Form 843, Claim for Refund and Request for Abatement. This form is filed directly with the IRS to request a refund of the erroneously withheld Tier I and Tier II taxes. The employee will need to attach a statement explaining the situation and include a copy of the incorrect W-2.