Tax Treatment of Severance Payments and Settlement …

1 This article was extracted from the 2014 Employment Law eBook. To view the entire eBook, please click Treatment of Severance Payments and Settlement AgreementsWe had earlier reported that the Sixth Circuit, in United States v. Quality Stores, Inc. (September 7, 2012), held that Severance Payments were not wages subject to FICA taxes. Quality Stores made Severance Payments to terminated employees and all payroll taxes, including FICA, were withheld. Because FICA taxes are matched by the employer, both the employ -er and the employee were required to pay the FICA tax.

2 Thereafter, Quality Stores filed for a tax refund, claiming that Severance plan Payments were supple-mental unemployment benefits (SUB), and, therefore, not wages subject to FICA. The Sixth Circuit agreed, reasoning that such Payments were not Payments for 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 about other Payments made to a severed em-ployee?

3 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, 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 Attorneys FeesLet s cover this issue first, since it s near and dear to an attorney s 2005, the United States Supreme Court ruled that attorney s fees are taxable income to the Plaintiffs.

4 Banks v. Commissioner, 543 426 (2005). Thus, they generate a 1099 Miscellaneous Income Notice. Nevertheless, the Plaintiffs are entitled to deduct the amount of fees above the line as deductions from income. Internal Revenue Code, Section Front and Back PayWhen an employer separates an employee from employment, there are many times when the employee receives Severance Payments as part of a Severance package. This may occur pursuant to a This article was extracted from the 2014 Employment Law eBook.

5 To view the entire eBook, please click in force, circumstances where an employer seeks to soften the blow of termination, or the employer requests as a quid pro quo for a separation package, the execution of a release protecting the employer from litigation by the employee . Are these amounts taxable? Generally, the payment of wages received as Severance Payments or as part of payment of wages for back pay and front pay pursuant to a lawsuit are treated as wages because indeed, the Payments are for pay . These amounts, therefore, must be treat-ed as wages, run through payroll, and are subject to withholding.

6 Any front pay and back pay Payments are for lost compensation and are supplemental , if a case is litigated and a former employee is awarded front pay or back pay in the suit, these amounts are subject to tax as wages and/or supple-mental income. The Third Circuit Court of Appeals has also indicated that pursuant to the Americans with Disabilities Act, a prevailing employee may be awarded an additional sum of money to pay for the increased tax burden of a back pay award. This seems like a double whammy . 3.

7 Emotinoal Distress, Physical Injury, and Medical Expense ReimbursementIt s clear that physical injury awards are excludable from income. Pursuant to the Internal Revenue Code, specifically Section 104(a)(2), however, the underlying causes of action must be based on a tort or tort type right and there must be a recovery for these kinds of actions based on personal physical distress is not typically considered a physical sickness or physical injury. Consequently, settlements in sexual harassment cases that did not result in some type of observable bodily harm such as bruises, cuts, etc.

8 , may result in the determination, at least in the IRS s eyes, that the recovery is consid-ered taxable income. While these awards may not be subject to payroll taxes, they may result in other in-come on a Form 1099-MISC. Be , Settlement Payments for medical expenses to treat emotional distress are typically not considered income. See 26 104(a). 4. Punitive DamagesWhat if an employee receives punitive damages through jury verdict? Are these taxable?In a word, yes. Punitive damages are taxable income to the recovering Plaintiff but again are not subject to payroll tax.

9 Punitive damages should be reported under a 1099-MISC. Nevertheless let s hope we never have to worry about this particular InterestPre-judgment interest, which may be awarded by a Court in certain kinds of cases, again is income to a Plaintiff but not subject to payroll taxes. This is a Form 1099-MISC reporting Settlement of an Employment Action and Allocations Made in the Settlement DocumentWhen an employer settles a claim or lawsuit with a disgruntled employee , there should be a final release entered into between the parties.

10 The employee s counsel will argue against including all of the settle-ment proceeds as income, to be run through pay-roll. As discussed above, clearly any award which in-cludes payment of attorney s fees should carve out the amount for attorney s fees from wages .What about the remaining amount? Because the underlying action or claim must be based on some discrimination or public policy claim, wage 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 article was extracted from the 2014 Employment Law eBook.