To Withhold or Not to Withhold: The Employment Tax Consequences of Settlements and Judgments

Weissman_William_webLitigation arising out of employment is a fact of life. When those cases conclude with payment, there are tax consequences that have to be addressed. This article provides a short primer on common tax issues associated with  these cases.

Law Governing Tax Treatment of Settlement Agreements

As the IRS and state tax agencies are not parties to settlements, they are not required to respect the tax consequences inherent in such settlements. As such, a settlement agreement’s characterization or division of settlement amounts is not binding on the government.[1] Rather, the IRS will look at these factors to determine whether to respect the agreement’s characterizations:

  • The nature of the claim that was the basis for actual settlement, but not its validity.[2] That determination is primarily a factual question that is generally made by reference to the settlement agreement.[3]
  • The payor’s intent or dominant reason for making payment.[4] However, intent of the parties is not controlling.[5] Rather, the courts will ask “in lieu of what were the damages awarded?”[6]

In addition, in order for the allocation in a settlement agreement to be respected, it must be entered into:

  • In an adversarial relationship.
  • At arm’s length.
  • In good faith.

It is not enough for the parties to reach a settlement figure in an adversarial relationship; rather, the allocation must also be based on adversarial positions. For example, in Robinson v. Commissioner, following a verdict for about $60 million, including $6 million for lost profits, $1.5 million for mental anguish and $50 for punitive damages, the parties settled for about $10 million. Plaintiff wanted to allocate 95 percent of settlement to mental anguish (which was not taxable at the time). The IRS rejected the settlement allocation because it was not based on a reasonable allocation consistent with the claims alleged in the lawsuit, and the court agreed.[7]

Tax Treatment of Typical Claims Made by Employees

Wage Related Claims

  • Back pay. Payments of wages are subject to employment taxes unless specifically exempted, and no statute or regulation exempts back pay from the definition of wages for tax purposes.[8] This is true even if the worker receiving the payment is no longer employed by the payor at the time of payment.[9]
  • Front pay. Front pay is also generally treated as wages because wages apply to the entire employee-employer relationship and not merely to work actually performed. The Fifth Circuit, however, has held that front pay is not “wages” because it represents a “‘loss in earning capacity,’ not for services already performed. ….”[10]
  • Family and Medical Leave Act. Amounts paid under the Family and Medical Leave Act are generally treated as wages. Courts in the Eastern District of Pennsylvania have held that such amounts are not for services in employment but rather damages that are equivalent to the amount of wages, and as such are not themselves wages. The IRS, however, does not agree, and in general it will consider amounts paid under the FMLA wages for tax purposes.
  • Refusal to hire cases. The IRS takes the position that claims based on failure or refusal to hire are back pay and thus wages.[11] However, the 8th Circuit has taken a contra view.[12] The court held that FICA tax and income tax withholding do not apply unless an actual employment relationship existed, and no such relationship existed if the person was never hired.

Emotional Distress and Personal Physical Injuries

Under Internal Revenue Code section 104(a)(2), amounts received on account of personal physical injury or illness are not income subject to tax. Prior to 1996, emotional distress was generally treated as exempt under section 104(a)(2). However, for payments made after August 21, 1996, emotional distress was carved out of section 104(a)(2). The IRS has defined personal physical injury or sickness requires an “observable bodily harm” such as bruising, cuts, swelling and bleeding.[13] In contrast, emotional distress generally includes physical or psychological distress. It also includes physical symptoms of the emotional distress, such as stomach aches, ulcers and headaches triggered by the distress.[14]

Payments on account of personal physical injuries are not reported, while emotional distress damages are reported on IRS Form 1099-MISC, box 3 (other income) if over $600. Emotional distress payments are not taxable, however, up to the amount of any unreimbursed medical expenses actually paid by the plaintiff. Accordingly, when fashioning a settlement, it is useful to know if such offsets exist. An emotional distress payment, while taxable income, is not wages, as it is not intended to be in lieu of wages paid in employment.[15]

Attorney’s Fees

Most settlements involve some payment of attorney’s fees. In two consolidated cases in 2005, the United States Supreme Court ruled that attorney’s fees are taxable income to the plaintiffs.[16] Therefore, attorney’s fees should be reported on a Form 1099-MISC, box 3, to the plaintiffs.

In addition, to the extent income is reported to an attorney, such income is reported on Form 1099-MISC, box 14, to counsel.[17]

Congress alleviated the problem of plaintiffs being taxed on attorney’s fees in most employment  litigation in the JOBs Act of 2004. A plaintiff may deduct attorney’s fees paid for discrimination cases that is above-the-line, making it potentially tax neutral, but only up to the amount of the settlement award.[18] This provision applies to payments made after October 22, 2004.[19]

In Revenue Ruling 80-364,[20] the IRS explained the income and employment tax consequences of interest and attorney’s fees being awarded by a court in connection with claims for back pay. Specifically, it stated that interest and attorney’s fees are generally not wages to the employee unless there is no specific allocation. The same principles should apply to settlements.

Liquidated Damages and Interest

Liquidated damages and interest are treated as taxable income but not wages.[21]

Incentive Payments to Named Class Representatives

There is little authority regarding whether incentive payments to named plaintiffs are treated for tax purposes. In Trotter v. Rankin[22] a federal district court held that $5,000 incentive payments made to class representatives were “wages,” and therefore subject to employment taxes. Trotter involved a typical employment related class action, in which the plaintiffs sought back pay and certain benefits. The settlement agreement allocated money based on hours worked and years of service. In addition, the named plaintiffs were each to receive a $5,000 incentive payment for the risk of stepping forward and being involved in the litigation process.

While in Trotter the court held that incentive payments were wages, the court’s decision was based in part upon: the fact that the only underlying claim was for wages; the Allocation Plan did not specifically allocate these payments separately; no claim had been made in the complaint for a separate payment; and the fact that the allocation was based on factors that could have included work on the lawsuit. Whether the same result would occur under different facts is unknown, but the IRS is likely to conclude, as the court did, that if the underlying claims were wage based, the incentive payments should also be treated as wages.

Penalties

California employment cases frequently involve penalty claims. For example, employees may claim Private Attorney General Act penalties[23] or waiting time penalties.[24]

Generally the use of the word “penalty” is not conclusive of its characterization for tax purposes.[25] Further, for tax purposes the label  placed upon payments is not determinative of its character.[26]

While penalties are generally not wages, there are some limited exceptions. For example, in Office of Chief Counsel Information Release 2005‑0094, March 17, 2005, the IRS stated that the payment required to be made under California Labor Code section 226.7 was a payment subject to FICA, FUTA and income tax withholding.

In Murphy v. Kenneth Cole Productions, Inc.,[27] the California Supreme Court distinguished between California Labor Code sections 203 and 226.7. The court held California Labor Code section 226.7 to be a “wage” rather than a penalty, while contrasting it with California Labor Code section 203, which it described as clearly being a penalty.[28]

While there have been a number of cases on the subject of whether the payment of an additional hour of pay per California Labor Code section 226.7 when a meal or rest period is not provided should be characterized as a wage or a penalty, the taxing agencies expect these payments to be processed as wages.  In most cases, however, penalties, if paid directly to employees, should be treated as income but not wages.

Analysis of the Tax Consequences of Allocations Made in a Settlement

From a taxing agency perspective, the primary concern with respect to an employer and a settlement agreement is whether a reasonable amount was allocated to wages, and thereafter the correct amount of taxes was withheld and remitted. To the extent that there may be multiple allocations for non-wage (but taxable) payments, there is little incentive for the taxing agency to address the matter with the employer, so long as it was reported on a Form 1099-MISC if more than $600 in total.

The natural starting place for determining whether the allocation made in a settlement agreement is appropriate is the complaint. Certain causes of action are only entitled to certain damages. For example, claims under the ADEA do not allow tort damages, and therefore no amount could be allocated to a claim under the ADEA for personal physical injuries.[29]

Once the claims and potential damages are determined, the relative strength of any claims should be reviewed. For example, a claim for back pay must be determined in light of whether the employee continued to be employed during the period at issue. Also, plaintiffs are obligated to mitigate their damages. Thus, it should be determined whether the employee obtained other employment, how quickly and at what rate of pay. In some cases, despite claims for back pay, the facts will demonstrate that the employee lost little in wages, either because he or she remained employed or obtained other employment quickly for the same or more  pay. In such situations the amount of a settlement reasonably allocated to wages may well be small relative to other payments made.

Further, the reasons for payment – based on whatever investigation has been performed – should be documented. Doing so will help in any audits of the settlement agreement. So, if investigation shows that a plaintiff claiming harassment had psychological treatment expenses, this may support a decision to allocate some payment for emotional distress and/or other damages for that claim.

Nonetheless, there is no bright line test for determining the reasonableness of an allocation. Often the amount of a settlement is less than the potential damages that could be awarded under one cause of action, let alone the entire complaint. This is particularly true when dealing with claims of various employment law violations on a class action basis. Thus, it becomes most critical to make sure that the negotiations process is well documented and conducted in an adversarial arm’s length manner. This, more than any other factor, is likely to establish that the allocations were reasonable.


William Hays Weissman is a shareholder in the Walnut Creek office of Littler Mendelson, P.C. who specializes in employment tax issues. He can be reached at wweissman@littler.com or (925) 927-4545.


Other articles you may be interested in:

What You Should Know About the Private Attorney General Act– Kevin R. Allen, Esq.
Employment Law Basics for Business Lawyers – Michelle Ferber and Stuart Goldware

Admissibility of a Plaintiff’s Immigration Status in California Employment and Personal Injury Cases – Ralph L. Jacobson and Yen P. Chau
Overtime Compensation Rights for Live-in Personal Care Attendants – Patricia M. Kelly
You Won! Now What? Three Tips When Applying for Prevailing Party Fees – Kevin R. Allen, Esq.
A Motivating Reason: Chipping Away at Pretext – Delia Isvoranu


[2] Bagley v. Comm’r (1995) 105 T.C. 396, 406; Allum v. Comm’r, T.C. Memo 2005-177.

[3] Robinson v. Comm’r (1994) 102 T.C. 116, 126.

[4] Knuckles v. Comm’r (10th Cir. 1965) 349 F.2d 610, 613; Metzger v. Comm’r (1987) 88 T.C. 834, 847.

[5] Dotson v. United States (5th Cir. 1996) 87 F.3d 682, 687.

[6] Alexander v. Internal Revenue Serv. (1st Cir. 1995) 72 F.3d 938, 942  (internal quotations and citations omitted).

[7] See also Vincent v. Comm’r, T.C. Memo 2005-95.

[8] IRC § 3401; United States v. Cleveland Indians Baseball Co. (2001) 532 U.S. 200.

[9] Treas. Reg. § 31.3401(a)-1(a)(5); Social Security Bd. v. Nierotko (1946) 327 U.S. 348, 365-366; Mayberry v. United States (8th Cir. 1998) 151 F.3d 855; Hemelt v. United States (4th Cir. 1997) 122 F.3d 204.

[10] Dotson, 87 F.3d at 690.

[11] Rev. Rul. 78-176.  Rev. Rul. 78-176 was cited with approval in Melani v. Board of Higher Ed. (S.D.N.Y. 1986) 652 F. Supp. 43, aff’d, 814 F.2d 653 (2d Cir. 1987).

[12] Newhouse v. McCormack (8th Cir. 1998) 157 F.3d 582.

[13] See IRS Private Letter Ruling 200041022.

[14] Conference Committee Report to the 1996 Act.

[15] 2011 Form 1099-MISC Instructions, p. 4.

[16] See Banks v. Commissioner (2005) 543 U.S. 426 (2005).  Whether attorney’s fees are income to a plaintiff under a fee shifting statute is unsettled (the Supreme Court in Banks declined to address the issue) and may depend upon state law. For example, under California law, when there is no contract providing for the disposition of such fees, they belong to the attorney that earned them. See Flannery v. Prentice (2001) 26 Cal.4th 572. Nonetheless, there is no definitive law yet on this issue from a tax reporting perspective. The IRS takes the position that even attorney’s fees paid under a fee shifting statute are still income to the plaintiff. PMTA 2009-035 (October 22, 2008).

[17] See also Treas. Reg. § 1.6045-5.

[18] IRC § 62(a)(20).

[19] There is also currently an administrative exception to the rule that attorney’s fees are income to the plaintiffs in claims made class action settlements. This exception is based on an IRS memorandum. While the legal justification for IRS position is somewhat suspect, because it benefits taxpayers, it has not been challenged. See Office of Chief Counsel Memorandum, PRENO-111606-07, May 18, 2007. Thus, to the extent that a settlement is a claims-made settlement, it should be possible to exclude the attorney’s fees from inclusion in income for the plaintiffs.  However, this is subject to change at the IRS’s discretion.

[20] Rev. Rul. 80-364, 1980-2 C.B. 294, 1980-52 I.R.B. 15.

[21] See, e.g., 2013 Form 1099-MISC Instructions (liquidated damages under ADEA not wages); Rev. Rul. 72-268 (liquidated damages are not wages subject to employment taxes); Kern v. Mid‑Continent Petroleum Corp. (N.D. Iowa 1945) 63 F. Supp. 120, aff’d 157 F.2d 310 (8th Cir. 1946) (liquidated damages under the FLSA are not “wages” for employment or income tax withholding purposes); 2013 Form 1099-INT (interest income); Rev. Rul. 80-364 (interest is not wages subject to employment taxes).

[22] Trotter v. Rankin (D. Del. 2003) 253 F. Supp. 2d 812.

[25] Smith v. Commissioner (1960) 34 T.C. 1100, 1104.

[26] Treas. Reg. §§ 31.3121(a)‑1(c); 31.3306(b)‑(1)(c); 3401(a)‑1(a)(2).

[27] Murphy v. Kenneth Cole Productions, Inc. (2007) 40 Cal. 4th 1094.

[28] Id., at 1108-1109.

[29] Commissioner v. Schleier (1995) 515 U.S. 323.

 

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