The Sophisticated Employer Blog

After months of hard work, you’ve finally arrived at the end of an employment dispute. Parties often spend considerable time focused on the amount of any settlement payments, but the tax treatment of the payments and any IRS filing requirements are no less important.

While it is true that a settlement agreement isn’t required to address taxes as a legal matter, as we learned in a previous blog on this subject, doing so can create significant problems for the parties and their attorneys. There are several important questions that should be addressed as part of the settlement before making any payments.

What is the character of the payments? How should the payment be made to the employee? How should the payment be reported to the IRS? Should any payroll or gross income tax be withheld from the settlement proceeds? How many checks should be written? Should attorney’s fees be separated from gross proceeds for the plaintiff?

Failure to properly address these questions as part of any settlement agreement can lead to other issues later including further litigation, future IRS challenges, and the unwillingness of the court to issue a satisfaction of judgement once all payments have been remitted by the employer. To assist with the crafting of agreements that appropriately consider these taxation questions, the IRS outlined a process to determine the correct treatment of employment related settlement payments. 

Determining the Character of Payment & Nature of Claim

The first step in any tax analysis of settlement proceeds should be to determine the character of the payment and the nature of the claim. Doing so will allow the parties to determine if the payment should be considered gross income or wages for the purposes of tax and filing requirements. A judgement or settlement may be comprised of several elements, including severance pay, back pay, front pay, compensatory damages, consequential damages, punitive and liquidated damages, and restoration of benefits.

In some cases, the court order may break down the amount of the settlement into the various elements. In a settlement or when the court does not fully allocate the proceeds, it will be important for the attorneys to determine the elements that comprise the total payment before the parties sign the agreement. This analysis alone will often offer strong indicators regarding the responsibilities of the parties to withhold taxes and file certain tax forms.

Payments made as part of or in connection with employee wages will be subject to federal employment tax. This includes payments made for severance pay, back pay and front pay. When making payments of this type, the employer should issue a W-2 to the employee and withhold employment taxes from any payments for employment pay. Employment taxes must be submitted to the IRS during the period that the wages were actually paid instead of the period during which the wages should have been paid. See United States v. Cleveland Indians Baseball Co., 532 U.S. 200 (2001)

Payments made for damages should be included in the employee’s gross income. This includes compensatory damages, consequential damages and punitive or liquidated damages. The employer should issue a 1099-MISC to the employee for payments made for damages.

IRC § 104(a)(2) Physical Injury or Physical Sickness Exception

Payments made to compensate an employee for damages related to physical sickness or injury are not subject to the normal tax or reporting requirements outlined above. Under IRC § 104(a)(2), payments made “on account of personal physical injuries or physical sickness” that would not be covered by a worker’s compensation claim are excludable from gross income. For a payment to be excluded under § 104, it must have been made as compensation for a tort or tort like injury or as reimbursement for medical treatment for emotional distress.

Damages must have been received through either a court judgement or settlement agreement to be excludable under the 104(a)(2) exception. A general release against an employer through a termination plan or severance package will not qualify for exclusion. The employer should not issue a 1099-MISC for damages excluded under this exception.

Settlement Agreements

Since damages recovered from an employment related case are generally not recoveries for personal physical injury, they should be included in the employee’s gross income.   As a general rule, the settlement agreement should require that there be at least two checks written—one to the attorney for their fees and another to the plaintiff. If the settlement results in a series of payments to the plaintiff over a period of time, these checks should be made payable directly to the plaintiff as well.

If the plaintiff attempts to claim that the settlement proceeds are excludable from their taxable income, the burden falls on them to prove this position to the IRS. See Getty v. Commissioner, 913 F.2d 1486 (9th Cir. 1990). If the settlement allocates damages to compensate a plaintiff for a physical injury or sickness, it is important that the agreement state the amount of the allocation that is attributable to the 104(a)(2) exclusion.

If the tax treatment of a settlement payment is challenged, the IRS and the U.S. Tax Court will place strong emphasis on the language in the agreement and the categorization of the payments. Many tax cases focus on the “intent of the payer” as outlined in the settlement agreement during an audit. In some cases, a well worded settlement agreement that fully outlines the payment elements and their respective tax treatment is enough to satisfy the IRS without the need for further inquiry. It is for this reason that attorneys should not disregard the tax considerations of any payments before the agreement is signed by the parties.

Reporting Requirements

The two methods for reporting payments made as part of a settlement are a Form W-2 for employment related payments and a Form 1099-MISC for any damages. The IRS requires that federal income taxes must be withheld and a W-2 issued regardless of whether the plaintiff is still an employee at the time of the settlement.

Employment related payments should be processed through the employer’s payroll when possible. The payroll check should outline any deductions as well as federal and state income tax. If the employer fails to withhold and remit the proper amount of taxes, they may be subject to additional liabilities, penalties, and interest. See 26 U.S.C. § 3509.

Any portion of the proceeds that are not subject to payroll taxes would be reported on a Form 1099-MISC. The types of payments that would be included on this form include attorney’s fees, punitive damages, emotional distress and other nonphysical injuries, and prejudgment interest. The amounts listed on Form 1099-MISC are paid to the plaintiff (or plaintiff’s counsel) and should not have taxes taken out of the initial payment.

Attorney Fees

Attorney fees received in a settlement in an employment dispute are taxable to the plaintiff, even if the fees are paid directly to the attorney. This is generally true even in cases where a fee-shifting federal or state statue is present. These attorney fees must be included in the gross income of the employee unless it is excludable under one of the following three exceptions.

First, attorney fees are not included in a plaintiff’s gross income if they are associated with a physical injury or sickness and the payments qualify for an exception under IRC § 104(A)(2).

Second, attorney fees paid directly to class counsel out of a settlement fund are not included in a class member’s gross income if (1) the class member did not have a separate contingency fee arrangement or retainer agreement and (2) the class action was an opt-out class action.

The third exception for when attorney fees are not included in a plaintiff’s income is when the fees are the expenses of another person or entity such as when a union files a claim on behalf of its membership. In this case, since the fees were generated through litigation initiated by the third party, they are attributable to that party, and the employee is only responsible for the payments allocated to them from the union settlement.

Generally speaking, attorney fees paid as part of an employment claim can be deducted from income as part of an income tax return to reduce the employee’s taxable income. Plaintiffs should be advised to seek guidance from a tax professional when considering a deduction for attorney fees to determine eligibility.

Indemnification Clause

Since not every settlement agreement will fully outline the responsibilities of the parties to report and pay taxes, employers can be left with exposure to future tax liabilities.

If the employee does not properly report the settlement income on their tax returns and pay any resulting tax, the IRS will first attempt to collect from the plaintiff. If the employee is subsequently deemed to not be collectible, the employer may be liable for the portion of taxes the IRS believes should have withdrawn from the settlement payment.

To protect itself from this potential outcome, the employer can include an indemnification clause in the settlement agreement that obligates the employee to compensate it for any possible tax liabilities arising from the employer’s failure to file and pay the necessary taxes.

If you are not sure what taxes should be paid or how a transaction should be reported, consult a tax attorney familiar with the rules for guidance.