Revenue Ruling 71-28: Taxing Payments for Seniority Rights
Explore the tax implications of Revenue Ruling 71-28, which classifies payments for relinquishing seniority rights as ordinary wages, not capital gains.
Revenue Ruling 75-44, issued by the Internal Revenue Service (IRS), provides guidance on the tax treatment of payments made to railroad employees for relinquishing job seniority rights. These payments are not for services rendered but are compensation for giving up established rights to a particular job or shift. The ruling establishes a clear framework for both the employer and employee, clarifying how these payments are classified for tax purposes. It addresses whether the funds are treated as regular earnings, which directly impacts how the money is taxed and reported.
Tax Characterization of the Payment
Revenue Ruling 75-44 determines that payments for the surrender of seniority rights are classified as ordinary income. This means the amount received is taxed at the employee’s standard marginal tax rate, just like regular wages. The IRS’s reasoning is that the payment acts as a substitute for the future wages the employee would have earned had they retained their seniority. It is compensation for the loss of future earning capacity.
This classification is distinct from a capital gain, which results from the sale of a capital asset like stocks or real estate. The IRS does not view an employee’s seniority rights as a capital asset. Instead, the rights are tied to the employment relationship and the potential for future earnings from that employer.
It is important to distinguish between payments for seniority rights and those made solely for reemployment rights. While a payment for giving up seniority is considered compensation, a payment made exclusively for relinquishing the right to be recalled for future employment is not. This type of payment is still treated as ordinary income for federal income tax purposes but is not subject to railroad retirement taxes.
Withholding and Payroll Tax Requirements
Because the payment for seniority rights is treated as ordinary income, it is also defined as “compensation” for railroad retirement tax purposes. This designation requires the employer to withhold several types of taxes directly from the payment. The employer is responsible for calculating and remitting these withholdings to the appropriate government agencies.
The primary withholding is for federal income tax, determined by the employee’s Form W-4 information. Additionally, these payments are subject to taxes under the Railroad Retirement Tax Act (RRTA), which funds the railroad retirement system. RRTA taxes are levied on both the employer and the employee, and the employee’s portion is withheld from the payment.
Reporting the Payment on Tax Forms
Reporting this income is straightforward because the employer handles the initial tax withholding. At the end of the tax year, the employee will receive a Form W-2, Wage and Tax Statement, from their railroad employer. This form will detail the total gross amount paid and the total federal income tax and RRTA taxes that were withheld.
The gross payment amount will be included in the total wages reported in Box 1 of the Form W-2. The federal income tax withheld will be shown in Box 2. Any RRTA compensation and tax withheld will be reported in designated boxes on the W-2, typically in Box 14.
When filing their annual income tax return using Form 1040, the employee will report the total wages from Box 1 on the line for wages, salaries, and tips. The federal income tax withheld from Box 2 is reported on the payments section of the Form 1040, which reduces the total tax owed or increases the potential refund. The employee does not need to perform a separate calculation for the payment, as it is already integrated into the W-2 figures.