Tax Treatment of Severance Payments and Settlement Agreements

We had earlier reported that the Sixth Circuit, in In 2005, the United States Supreme Court ruled that United States v. Quality Stores, Inc. (September 7, attorney’s fees are taxable income to the Plaintiffs. 2012), held that severance payments were not Banks v. Commissioner, 543 U.S. 426 (2005). Thus, subject to FICA taxes. Quality Stores made severance they generate a 1099 Miscellaneous Income Notice. payments to terminated employees and all Nevertheless, the Plaintiffs are entitled to deduct the taxes, including FICA, were withheld. Because FICA amount of fees “above the line” as deductions from taxes are matched by the employer, both the employ- income. Internal Revenue Code, Section 162. er and the employee were required to pay the FICA tax. Thereafter, Quality Stores filed for a tax refund, 2. Front and Back Pay claiming that severance plan payments were supple- When an employer separates an employee from mental benefits (SUB), and, therefore, , there are many times when the not wages subject to FICA. The Sixth Circuit agreed, employee receives severance payments as part of reasoning that such payments were not payments for a severance package. This may occur pursuant to a services under FICA, but rather payments related to the elimination of employment. This ruling by the Sixth Circuit is in direct conflict with the Federal Cir- cuit’s decision in CSX Corp. v. United States, a 2008 decision. Consequently, the United States Supreme Court has agreed to hear the issue and make the final determination.

What about other payments made to a severed em- ployee? What about payments made to an employee who has been terminated or left and then received payments from the employer pursuant to a settle- ment or judgment with the employer based on a dis- crimination lawsuit, public policy claim, etc.?

The remainder of this article will cover, in general, various kinds of payments made by an employer to a former employee and the tax consequences of those payments.

1. Attorneys’ Fees Let’s cover this issue first, since it’s near and dear to an attorney’s heart.

This article was extracted from the 2014 Employment Law eBook. To view the entire eBook, please click here. reduction in force, circumstances where an employer result in some type of observable bodily harm such seeks to “soften the blow” of termination, or the employer as bruises, cuts, etc., may result in the determination, requests as a quid pro quo for a separation package, the at least in the IRS’s eyes, that the recovery is consid- execution of a release protecting the employer from ered taxable income. While these awards may not be litigation by the employee. Are these amounts subject to payroll taxes, they may result in “other in- taxable? come” on a Form 1099-MISC. Be careful.

Generally, the payment of wages received as Finally, settlement payments for medical expenses to severance payments or as part of payment of wages treat emotional distress are typically not considered for back pay and front pay pursuant to a lawsuit are income. See 26 U.S.C. 104(a). treated as wages because indeed, the payments are for “pay”. These amounts, therefore, must be treat- 4. Punitive Damages ed as wages, run through payroll, and are subject to What if an employee receives punitive damages withholding. through jury verdict? Are these taxable?

Any front pay and back pay payments are for “lost In a word, yes. Punitive damages are taxable income compensation” and are supplemental wages. to the recovering Plaintiff but again are not subject to payroll tax. Punitive damages should be reported So, if a case is litigated and a former employee is under a 1099-MISC. Nevertheless let’s hope we never awarded front pay or back pay in the suit, these have to worry about this particular issue. amounts are subject to tax as wages and/or supple- mental income. The Third Circuit Court of Appeals 5. Interest has also indicated that pursuant to the Americans Pre-judgment interest, which may be awarded by a with Disabilities Act, a prevailing employee may be Court in certain kinds of cases, again is income to a awarded an additional sum of money to pay for the Plaintiff but not subject to payroll taxes. This is a Form increased tax burden of a back pay award. This seems 1099-MISC reporting requirement. like a “double whammy”. 6. Settlement of an Employment Action and 3. Emotinoal Distress, Physical Injury, and Medical Allocations Made in the Settlement Document Expense Reimbursement When an employer settles a claim or lawsuit with a It’s clear that physical injury awards are excludable disgruntled employee, there should be a final release from income. Pursuant to the Internal Revenue entered into between the parties. The employee’s Code, specifically Section 104(a)(2), however, the counsel will argue against including all of the settle- underlying causes of action must be based on a tort ment proceeds as “income,” to be run through pay- or tort type right and there must be a recovery for roll. As discussed above, clearly any award which in- these kinds of actions based on personal physical cludes payment of attorney’s fees should carve out the sickness. amount for attorney’s fees from “wages”.

Emotional distress is not typically considered a What about the remaining amount? Because the physical sickness or physical injury. Consequently, underlying action or claim must be based on some settlements in cases that did not discrimination or public policy claim, and hour

Make sure your release includes a proper “indemnification” clause so that if there is any question or the IRS comes after the employee’s amounts on the division allocated to the “lost wages”, the employer is indemnified for such claims.

This article was extracted from the 2014 Employment Law eBook. To view the entire eBook, please click here. claim, or similar type claim, some portion of the set- tlement amount should be attributable to lost wages, front or back pay, or the like. How much? First, make sure your release includes a proper “indemnification” clause so that if there is any question or the IRS comes after the employee’s amounts on the division allocated to the “lost wages”, the employer is indem- nified for such claims.

The bottom line, is that any settlement agreement should be analyzed as to whether or not a reasonable amount of the award is allocated to wages. From the settling employer’s perspective, the question is whether or not there is any incentive from the IRS to come back to the employer or address the mat- ter with the employer, rather than contest any issues with the recovering party. If there is a “reasonable amount” allocated as wages, and depending on the size of the settlement such that the IRS has little incentive (both in terms of the amount of the recov- ery in question and recognizing its exploding respon- sibilities and back log of work), the settling employer should hopefully be “fine”. Since there is no magic line regarding allocation, and the settlement is arm’s length between the parties, the normal documenta- tion of the negotiation process, and the adversarial arm’s length discussions resulting in the settlement should go a long way toward answering any govern- ment’s “second guessing” of an allocation of settle- ment monies among its various components.

CONCLUSION Yes, an employer may have to “run through payroll” a portion of the former employee’s “settlement check”, but the accountants these days are, unfortunately, used to this request. The argument to the employee who doesn’t want “their money withheld” needs to be that, first, it is the law and, second that if they are entitled to a refund on some of the withholding, they will eventually receive the money as a refund based on the total monies and total withholdings. That doesn’t change the withholding requirements of the law regarding settlement monies received.

______Felix J. Gora, Esq. [email protected]

This article was extracted from the 2014 Employment Law eBook. To view the entire eBook, please click here.