Most settlements of employment-related claims are taxable. Plaintiffs often want to minimize this tax burden and claim that some or all of the settlement is not on account of lost wages, but rather on account of other damages. This way, the plaintiff will avoid the immediate tax withholding but also the Social Security and Medicare taxes altogether. The employer, of course, also avoids the withholding on the employer contributions. Let's face it though, most employment-related claims contain some element of back pay, front pay or both as damages. Because both parties generally benefit by classifying settlement payments as non-wages, the IRS typically believes that such a negotiation is not at arm's length and that the parties are avoiding the payment of these taxes.
Generally speaking, an allocation of the settlement between non-wage and wage related damages must be reasonable and must be based upon the facts and circumstances of the case. Therefore, if there is an employment-related claim that involves back pay or front pay, at least some portion of the settlement should be allocated to wages. It is not necessary to allocate 100% of the settlement amount to wages if there are also non-wage damages claimed. In contrast, allocating $1.00 to wages is not going to be reasonable under the IRS's view.
The IRS believes that any type of severance pay in exchange for a release is considered taxable wages and must be treated as such. Liquidated damages and other types of compensatory damages not related to wages are not considered wages for income tax purposes.
Damages for emotional distress are considered non-wage income but are taxable. There is an exception in the Internal Revenue Code §104(a)(2) for actual out-of-pocket medical costs incurred by an employee for emotional distress. However, such medical costs could not have already been deducted on the employee's tax return.
Many times plaintiff's attorneys also want checks made payable directly to their firm or paid jointly to the plaintiff and the law firm. Wage payments should be paid directly to the employee and reported on a form W-2 directly to the employee. Payments that are made for either attorney's fees and/or other allocated damages are reported on Form 1099. When an employer cuts a check directly to the plaintiff's attorney, the 1099 for that amount is issued to the attorney and a separate Form 1099 for the full amount of the settlement is issued to the plaintiff. The plaintiff can then deduct the attorneys' fees from his/her income. If one check is paid to both the attorney and the plaintiff, a Form 1099 for the full amount of the settlement should be issued for the attorney and the plaintiff.
When negotiating with an employee to either resolve a claim or enter into a severance agreement, the government is going to take its fair share and it is a factor for both sides to consider. Allocations should be appropriate and reasonable under the circumstances and no indemnity clause in a settlement agreement is going to save an employer from the IRS.
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