Taxing Workplace Settlements

Although most cases are resolved by settlement, not every lawyer appreciates the tax ramifications of settlement payments, particularly in the context of employment litigation. Payments made pursuant to an employment-related settlement fall into the following categories:

• wages or salary, subject to W-2 reporting;
• neither wages nor salary, but income that must be reported to taxing authorities;
• payment that is not income but must be reported; and
• payment that is not income and need not be reported.

When a case is resolved, it is crucial for employers, employees, and counsel to understand the tax implications. They should know which portions of a settlement are subject to taxation and the proper procedures for complying with both the Internal Revenue Code (tax code) and the Regulations of the Internal Revenue Service (Treas. Regs.). Employers settling employment-related claims may have to pay payroll taxes, take proper withholdings, file information returns for 1099 income-or none of the above, depending on the circumstances. The improper characterization of a payment could result in an unwanted tax controversy with the IRS, not to mention substantial monetary consequences. The best approach is to know the rules and plan accordingly, so both sides can negotiate a fair settlement that will truly end the dispute.

Is It Taxable?

To begin with, it is important for employers to distinguish between taxable and nontaxable settlement payments. That's because employers that misclassify settlement payments as 1099 income instead of W-2 income can be liable for the unpaid tax burden of the settlement proceeds, interest, and penalties (26 U.S.C.§3509; see also Treas. Reg. § 31.3403-1) (26 U.S.C. §§ 3509, 6651(a)(2) and (3), and 6656(a)).

The general rule for employers is that all payments to employees are taxable, unless the income is exempted by a specific section of the tax code. (26 U.S.C. § 61.) Whether payments are subject to taxation as wages or salary (requiring withholding and payment of payroll taxes), or as 1099 income (no withholding) depends on the reason for the payment and, in some cases, how it's characterized in settlement documentation. (See Parkinson v. Comm'r, 2010 WL 2595005 (Tax Ct. Mem. Decis.).)

The central question in determining whether a payment is taxable is: In lieu of what was the settlement amount paid? (Bagley v. Comm'r, 105 T.C. 396, 406 (1995), aff'd, 121 F.3d 393 (8th Cir. 1997).) Accordingly, allotting portions of the settlement payment to specific damages alleged by the former employee will help employers determine which portions of the settlement payment are taxable.

Here we review several of the more common items, along with their tax implications.

Lost Compensation

When employees seek damages from their former employer, they usually do so via a variety of claims, such as breach of contract, unpaid overtime, and alleged work "off the clock." (Cal. Lab. Code §§ 510 and 512.) Lost compensation claims may seek back pay for wages the employee did not receive for work performed; they may also involve work that should have been performed, in which case the monetary recovery is referred to as "front pay" for wages that would have been earned but for the employer's allegedly unlawful action.

Settlement payments for lost compensation are generally taxable to the employee and deductible to the employer. Withholdings and the payment of payroll taxes are required when settlement payments are made for lost compensation.

Interest Income

When settlement dollars compensate an employee for lost interest, the payment is treated as taxable income to the recipient. However, interest payments are not subject to payroll taxes or withholding. (Greer v. Comm'r, 2000 WL 37725 (Tax Ct. Mem. Decis.).) Interest income must be documented in a Form 1099. (26 U.S.C. § 6041; Treas. Reg. § 1.6041-1(b).)

Physical Injury

The tax code expressly excludes from gross income those payments intended to compensate litigants for "injuries" or "sickness." (26 U.S.C. § 104(a)(2).) Congress amended section 104 in 1996 via the Small Business Job Protection Act (Pub. L. No. 104-188), adding the word physical to qualify the words injuries and sickness. Thus, settlement payments for damages relating to alleged physical injury or physical sickness are not taxable. (See H.R. Rep. No. 104-737, at 301 (1996) (Conf. Rep.) (providing an example that damages received for a loss-of-consortium claim due to the physical injury or physical sickness of a spouse are excludable from gross income).)

In addition, settlement payments received on account of personal physical injury or physical sickness are not reportable as 1099 income. (The IRS offers a helpful publication: "Lawsuits, Awards, and Settlements Audit Techniques Guide.") Although section 104(a)(2) of the code does not define "physical injury" or "physical sickness," the IRS has provided some guidance, noting that "physical injury" requires either observable or documented bodily harm, such as bruises, cuts, swelling, or bleeding. (See IRS Ofc. of Chief Counsel Mem. 2009-035 (Oct. 22, 2008).) The IRS has also said that a settlement payment made to compensate for alleged loss of consortium, survival, and wrongful death would not be taxable because the claims arose from the physical sickness of the claimant's husband: cancer, caused by asbestos fiber inhalation. (See I.R.S. Priv. Ltr. Rul. 200121031, 2001 WL 564931 (Feb. 26, 2001).)

Emotional Distress

Section 104(a)(2) specifically provides that emotional distress is not to be treated as a physical injury or physical sickness. Because no statutory exemption is available, settlement payments that compensate for emotional distress are generally taxable-even when physical symptoms occur as a result of the emotional distress. (See Shelton v. Comm'r, 2009 WL 1456477 (Tax. Ct. Mem. Decis.).) The legislative history of the Small Business Job Protection Act of 1996, and tax court cases, note that the symptoms of emotional distress can include but are not limited to insomnia, headaches, stomach disorders, depression, skin irritation, appetite loss, asthma, and sleep deprivation. (See H.R. Rep. No. 104-737, at 301 n. 56 (1996) (Conf. Rep.), 1996-3 C.B. 741, 1041; see also Lindsey v. Comm'r, 2013 WL 1052772 (Tax. Ct. Mem. Decis.).)

Tax courts have recognized two separate exceptions to this rule. Payments for emotional distress will not be taxable:

if the damages are caused by a physical injury or physical sickness; and

to the extent the damages do not exceed payments made for medical care attributable to emotional distress.(Moulton v. Comm'r, 2009 WL 416010 (Tax. Ct. Memo. Decis.); see also Smith v. Comm'r, 2014 WL 4652904 (Tax. Ct. Summ. Op.).)

Therefore, if the individual's claims of emotional distress are attributable to a physical injury or physical sickness, the settlement payment can be treated as compensation for physical injuries or physical sickness-and the payment will be exempt from taxation under section 104(a)(2) and need not be reported. (See Conf. Rep. at 301 n. 56; IRS Publication 4345 (Rev. Nov. 2011).)

With regard to the second exception, "the exclusion from gross income specifically applies to the amount of damages received that is not in excess of the amount paid for medical care attributable to emotional distress." (See Moulton, 2009 WL 416010 at *4.)

If neither of these two exceptions applies, any emotional distress payment is income and must be reported in a Form 1099.

Punitive Damages

Punitive damages are generally taxed as part of gross income, but they are not subject to payroll taxes. Even when awarded in connection with settlement payments for physical injuries and physical sickness, punitive damages are not excluded from gross income. (See Greenberg v. Comm'r, 2011 WL 240101 (Tax. Ct. Memo. Decis.).) This rule is set forth specifically in the code; the section 104(a)(2) exclusion is for payments "other than punitive damages." Punitive damages received in a settlement payment are reportable as 1099 income.

Although generally not applicable in the employment context, an exception to this general rule is a wrongful death case. (See 26 U.S.C. § 104(c)(1).)

Attorneys Fees

All parties should be aware that the payment of attorneys fees is generally taxable to the litigant, regardless of the type of fee arrangement-whether hourly, flat, or contingent. This rule applies even if the fees are not paid directly to the litigant. (See Treas. Reg. § 1.6041-1(f); Comm'r v. Banks, 543 U.S. 426, 430 (2005).) Attorneys fees are taxable to the claimant and reportable as 1099 income, but they are not wages and are not subject to tax withholding. (See Rev. Rul. 80-364 (1980).)

Liquidated Damages

Liquidated damages included in a settlement agreement do not constitute wages for federal employment tax purposes, even if they are owed for a violation of the Fair Labor Standards Act of 1938. (See Rev. Rul. 72-268 (1972).) Accordingly, though employers are not required to take tax withholdings from portions of the settlement payment that provide for liquidated damages, those portions of the payment are still reportable as 1099 income to the claimant.

Reporting, Withholding, and Payroll Taxes

As noted, employers are required to report settlement payments to the IRS depending on the characterization of, and intent behind, the settlement proceeds. Payments that compensate a litigant for wage-related losses must be reported in a Form W-2, just as if they were paid by the employer for regular hours worked. (See 26 U.S.C. § 6051; Treas. Reg. § 31.6051-2(a).) Employers will accordingly deduct applicable taxes and withholdings (for Social Security, Medicare, and the like), and must pay the matching taxes to the IRS. (See 26 U.S.C. § 3402(a).) The Supreme Court has ruled that payroll taxes relating to a back-pay settlement are based on the year that the employees received the money, not the year in which the wages should have been paid. (See United States v. Cleveland Indians Baseball Co., 532 U.S. 200, 219 (2001).)

If a settlement payment constitutes taxable income but is not allocated to lost wages-such as a payment for physical injuries, punitive damages, liquidated damages, and interest-it needs to be reported in a Form 1099. (See 26 U.S.C. § 6041; Treas. Reg. § 1.6041-1(b).)

But if the payment is not taxable at all, the employer doesn't have any reporting, withholding, or payroll tax obligations.

Best Practices

Often employers agree to pay a single lump sum to settle multiple types of damages. If only a portion of the settlement payment is taxable, how is the employer to determine the extent of its reporting, payroll tax, and withholding obligations? Here are several steps to take.

First, employers should make sure that the settlement agreement expressly states the allocation of the payment(s). This practice is strongly encouraged because a settlement agreement entered into between adversarial parties in good faith and at arm's length-which expressly allocates the settlement proceeds among multiple types of claims or damages-is generally binding for tax purposes. (See Bagley v. Comm'r, 105 T.C. 396, 406 (1995), aff'd, 121 F.3d 393 (8th Cir. 1997).)

The parties may also choose to submit the settlement agreement to a court to confirm that the allocation of damage amounts is reasonable. Court approval of the settlement agreement decreases the likelihood of a challenge to the allocation of the settlement payment because it lessens the appearance that the litigant and employer colluded to gain the most favorable tax status. Such challenges are more likely to arise when very little of the settlement payment is allocated to wages. Accordingly, a court's approval will assist the parties in negating any adverse inference by the IRS. If the parties do not specify the allocation of a lump sum settlement payment, the IRS will determine the allocation by reference to the underlying nature of the claims alleged and to the evidence of the payor's intent in settling those claims. The tax courts will determine the payor's intent by reviewing "all the facts and circumstances of the case, including the complaint that was filed and the details surrounding the litigation." (Domeny v. Comm'r, 2010 WL 114287 (Tax Ct. Memo. Decis.).) Though the IRS is less likely to accept an after-the-fact allocation made by the parties, it may be sustained if there is contemporaneous, extrinsic evidence (such as attorney notes, settlement offers and counteroffers, or interrogatory responses) to support it.

Employers may further protect themselves from incurring additional tax liabilities, financial penalties, and interest payments by including an indemnity clause in the event the settlement allocation is challenged. The clause should note that the litigant will be responsible for any taxes, penalties, or interest assessed against either the litigant or the employer as a result of the settlement, and that the claimant agrees to indemnify, defend, and hold harmless the employer for any such taxes, penalties, or interest resulting from the settlement agreement.

Note, however, that a promise of indemnification is only as good as the assets of the indemnifier. The employer may still be held liable for any penalties, taxes, or interest due if the litigant lacks the resources to engage in protracted litigation with the IRS.

Despite the foregoing, it's not just doom and gloom-tax wise-for the employee who recovers a settlement. When Congress passed the American Jobs Creation Act of 2004 it enacted section 62(a)(20) of the tax code, which provides for an above-the-line deduction for attorneys fees and court costs paid in connection with discrimination and certain other suits. In 2006 another provision was added to expand this rule to whistleblower cases. (See 26 U.S.C. §§ 62(1)(20) and (21).) So although the employee must acknowledge the income flowing from the settlement of an employment dispute, there is also available a deduction for certain attorneys fees and costs.

The key is to properly account for everything.

Consult an Expert

The tax treatment of settlement agreements is complicated. Considering that a false step can require the parties to pay a significant financial penalty, all counsel in the case should make sure they are abreast of the relevant tax laws.

Employers and employees alike will have the best chance of avoiding unwanted (and unplanned) tax liabilities if they correctly (and expressly) allocate settlement payments; seek court approval of the settlement; and include an indemnification clause in the settlement agreement. Attorneys for all parties in these cases should strongly consider consulting with an experienced tax practitioner so there are no surprises after the settlement check has been cashed.

Alan S. Levins is a shareholder and Jason E. Shapiro an associate at Littler Mendelson in San Francisco. They represent employers in employment litigation.

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