Taxation of Terminations, Settlements and Judges

Transcription

1 2015 YLD Bridge the Gap Seminar Taxation of Terminations, Settlements and Judges 11:30 a.m.-12:00 p.m. Presented by: David Repp Dickinson Mackaman Tyler & Hagen PC 699 Walnut St. Suite 1600 Des Moines, IA Phone: Thursday, May 14, 2015

2 Taxation of Terminations, Settlements and Judgments by David M. Repp 4/10/2015 Unless specifically exempted, every employer making payment of wages to an employee is required to withhold Federal income taxes and to pay such withheld taxes to the United States Treasury. IRC 3402(a)(1). The term wages is defined as all remuneration for services performed by an employee including the value of remuneration paid in a medium other than cash unless specifically excluded. IRC 3401(a). A similar (but not identical) set of rules apply to FICA withholding. IRC 3101; 3121(a). This article discusses some of the more common forms of compensation paid to a terminating employee and whether such payments are subject to income tax and FICA withholding. Severance Pay. The most common type of payment to a terminated employee is severance pay, which is taxable compensation income. IRC 61; Ramella v. Comr TCM 177. Severance pay is taxable even if, as part of their separation agreements, departing employees sign waivers releasing their former employers from potential future claims, including claims of unlawful discrimination. Webb v. Comr., 1996 TCM 50; Sodoma v. Comr., 1996 TCM 275; Foster v. Comr., 1996 TCM 276. Amounts paid to a terminated employee are compensatory and taxable as severance pay, even where the employer had no legal obligation to make the payments. Schwartz v. Comr., 1989 TCM 97. Severance or dismissal pay is treated as supplemental wages and fully subject to federal income tax withholding. IRC 3402(o); Treas. Reg (a)-1(b)(4). The IRS allows two alternative withholding methods on severance pay: the flat rate method and the aggregate method. IRS Information Letter Optional flat rate withholding method. This method allows an employer to withhold from the severance payment at a flat rate of 25% without regard to the employee's filing status or allowances claimed on Form W-4. An employer may only use this method if it has also withheld income tax from regular wages paid to the employee during the same calendar year as the severance payment, or in the preceding calendar year if the supplemental wages are separately stated on the employer's payroll records. Aggregate method. Under the aggregate method, the employer adds the supplemental and regular wages (if any) for the most recent payroll period in the current year together, and then figures the income tax withholding as if the total were a single payment. This calculation takes into consideration the employee's filing status and withholding allowances. Employers may use this method in any situation where they are paying an employee supplemental wages that do not exceed $1 million in a calendar year. Severance pay is also subject to FICA tax withholding. U.S. Quality Stores, Inc. U.S. 134 S.Ct (2014). The Court, in a unanimous decision, observed that 699 Walnut Street, Suite 1600, Des Moines, IA Phone: Fax:

3 TAXATION OF TERMINATIONS, SETTLEMENTS AND JUDGMENTS Page 2 Congress used extremely broad language in defining wages for FICA purposes and that severance payments clearly fall within that definition. There is a certain, limited, exception from FICA tax when severance payments are tied to the receipt of state unemployment benefits. In such case, the payments are exempt from FICA taxation but not income tax withholding. Rev. Rul This would seem to be contrary to the Supreme Court s decision in U.S. Quality Stores, Inc. which held that wages for FICA is defined broadly and includes severance pay. The Court identified this inconsistent treatment by the IRS in Revenue Ruling Consequently, the IRS has been given a green light by the Supreme Court to tax supplemental unemployment benefits for FICA tax purposes if it so desired. Back Pay. Back pay is compensation paid to an individual to compensate him or her for pay he or she would have received up to the time of settlement or court award but for the employer's wrongful conduct. For example, back pay is awarded to an employee if he or she is illegally terminated by an employer, or to an applicant for employment who is not hired for illegal reasons. In most cases, back pay is taxable, subject to FICA and income tax withholding, and must be reported on Form W-2 in the year payment is received (rather than the year payment should have been received). Cleveland Indians Baseball Co. v. U.S. 532 U.S. 200 (2001). Back pay for lost wages received on account of personal physical sickness or physical injury is not subject to FICA and income tax withholding. Anderson v. United States, 929 F.2d 648, 654 (Fed. Cir. 1991) (payments which are excluded from IRC 61 s definition of gross income are not subject to income tax or FICA withholding). In the Eighth Circuit, back pay (and front pay) awarded for an illegal refusal to hire is not subject to FICA and income tax withholding. Newhouse v. McCormick & Co., 157 F.3d 582; 82 AFTR 2d (8 th Cir. 1998) (explaining that no employment relationship existed so character of the payment could not be wages ). However, the back pay is taxable to the recipient and reportable by the payer on Form 1099-MISC, Box 3 Other Income. In every other Circuit, such back pay is subject to FICA and income tax withholding and reportable on Form W-2. Rev. Rul ; see also IRS Publication 957. Front Pay. Front pay is paid to an individual to compensate him or her for pay he or she would have received after the settlement date or court award but for the employer's wrongful conduct and the circumstances e.g., extreme animosity between the employer and employee which make it impracticable to place the employee in the position. Front pay in all Federal Circuit courts except the Fifth Circuit is considered wages subject to FICA and income tax withholding and must be reported on Form W-2. Gerbec v. United States, 164 F.3d 1015, 1026 (6th Cir. 1999); Mayberry v. United States, 151 F.3d 855, 860 (8th Cir. 1998); and Hemelt v. United States, 122 F.3d 204, 209 (4th Cir. 1997). The Fifth Circuit holds that only back pay is subject to FICA and income tax withholding. Dotson v. U.S., (CA ) 78 AFTR 2d ( wages is compensation for services already performed, not for services that will not be performed). However, front pay in the Eighth Circuit is exempt from FICA and income tax withholding when no employment relationship existed. Newhouse v. McCormick & Co., 157 F.3d 582; 82 AFTR 2d 699 Walnut Street, Suite 1600, Des Moines, IA Phone: Fax:

4 TAXATION OF TERMINATIONS, SETTLEMENTS AND JUDGMENTS Page (8 th Cir. 1998) Employment Contracts. An amount paid to an employee as consideration for cancellation of an employment contract and relinquishment of contract rights is ordinary income, and wages for purposes of FICA, FUTA, and Federal income tax withholding. Rev. Rul Prior to the issuance of Revenue Ruling , severance payments made to an employee in consideration for early termination of an employment contract was not considered wages or compensation, but ordinary income and not subject to FICA, FUTA or income tax withholding. Rev. Rul ; Rev. Rul ; Rev. Rul Amounts Paid in Settlement of Personal Injury Suits. Damages and other amounts received on account of certain personal injuries or sickness are excludable from the recipient s income. Code Sec. 104(a)(2). This rule applies to amounts received as a result of a lawsuit or the settlement of a lawsuit or under workers compensation acts. In the past, the rule was liberally applied and permitted the exclusion of amounts received on account of nonphysical, tort or tortlike injuries such as emotional distress. However, as a result of a law change, for amounts received after August 20, 1996, and in tax years ending after that date, Code Sec. 104(a)(2) has been amended to provide that the exclusion applies to damages other than punitive damages that are received on account of personal, physical injuries or physical sickness. Code Sec. 104(a)(2), as amended by the Small Business Job Protection Act of 1996 (P.L ). In addition, if an action has its origin in a physical injury or physical sickness, then all damages (other than punitive damages) that flow therefrom are treated as payments received on account of physical injury or physical sickness whether or not the recipient of the damages is the injured party. For example, damages (other than punitive) received by an individual on account of a claim for loss of consortium due to the physical injury or physical sickness of such individual s spouse are excludable from gross income. Conf. Rept. to the Small Business Job Protection Act of 1996 (P.L ); PLR (taxpayer s loss of consortium claim excludable resulting from spouse s asbestos-related disease). In addition, damages (other than punitive) received on account of a claim for wrongful death continue to be excludable from taxable income as under prior law. Damages Received on Account of a Nonphysical Injury or Sickness, Such As Age Discrimination or Injury to Reputation, Are Not Excludable From Gross Income. The 1996 amendment to Code Sec. 104(a)(2), in effect, prospectively overturns court decisions which held that damages attributable to nonphysical personal injuries or sickness may be excludable under that section. As under the former rule, the IRS clearly views back pay received in satisfaction of a claim for denial of a promotion due to employment discrimination under Title VII as taxable income because it is not attributable to a personal injury or sickness. Rev. Rul Damages for emotional distress and the physical symptoms of emotional distress may not be treated as damages on account of a personal, physical injury or sickness, except for amounts paid for medical care that is attributable to emotional distress. Code Sec. 104(a), as amended by P.L ; Rev. Rul ; Wells v. Commissioner, TC Memo However, damages for emotional distress and similar nonphysical injuries or sickness remain excludable from a 699 Walnut Street, Suite 1600, Des Moines, IA Phone: Fax:

5 TAXATION OF TERMINATIONS, SETTLEMENTS AND JUDGMENTS Page 4 recipient s taxable income to the extent that they are attributable to a physical injury or sickness House Committee Report to P.L Payroll Withholding on Amounts in Settlement of Personal Injury Suits and Nonphysical Injury Suits. Personal injury damages are not wages for purposes of FICA, FUTA and income tax withholding. Anderson v. United States, 929 F.2d 648, 654 (Fed. Cir. 1991) (payments which are excluded from IRC 61 s definition of gross income are not subject to income tax or FICA withholding); I.R.C. 3121(a), 3306(b) and 3401(a) (defining wages subject to withholding as remuneration for employment ). Any other portion of a settlement payment which does not represent wages, such as attorney fees and interest, and even emotional distress, is not subject to payroll taxes, provided the settlement or judgment makes a specific allocation indicating the amount of nonwage payments. Rev. Rul ; TAM (emotional distress payment not subject to employment tax; provides nice summary of FICA and tax withholding rules). If no allocation is made, the Internal Revenue Service will treat the entire payment as wages subject to payroll taxes. Rev. Rul In addition, the emotional distress must be documented and the allocation reasonable. TAM Therefore, if unnecessary payroll taxes are to be avoided, it is crucial that the settlement agreement or judgment clearly indicate how much of the total amount received by the plaintiff constitutes wages subject to withholding and how much represents other types of payments. If the other type of payment is for emotional distress, the emotional distress must be real and not simply fabricated at the time of settlement. TAM The Eighth Circuit recently overruled a long standing IRS rule that an employer has an obligation to withhold income and FICA taxes for employment discrimination even if an employer/employee relationship never existed. Newhouse v. McCormick & Co. 82 AFTR2d (10/2/98, CA8). The taxpayer, Newhouse, worked for McCormick for 23 years before being terminated as a result of outsourcing. He worked for an unrelated employer for five years before applying for a new position at McCormick & Co. but was denied employment due to age discrimination. A district court granted Newhouse a large settlement for lost back pay and front pay. McCormick & Co. withheld income tax and FICA tax on the settlement payments but Newhouse complained and filed suit demanding that McCormick & Co. pay the entire amount. The Eighth Circuit agreed with Newhouse saying that if no employment relationship ever existed, the settlement payments cannot be subject to employment taxes (such as FICA) and income tax withholding. This is contrary to the IRS position set forth in Rev. Rul and in other Circuits, but it is now the law in the Eighth Circuit. Even though the court held that no wage withholding or FICA tax was applicable, settlement payments are still subject to income tax to the recipient. Misclassification of Employment Status Can Result In Large Penalties. Employers that misclassify employees as nonemployees or independent contractors will face substantial financial penalties as the result of not withholding income tax, failing to withhold and pay employment taxes, and failing to file the correct reports and returns with the IRS, Social Security Administration (SSA), and state government agencies. The IRS penalty for unintentionally failing to withhold federal income tax is 1.5% of the wages paid. This assessment is doubled to 699 Walnut Street, Suite 1600, Des Moines, IA Phone: Fax:

6 TAXATION OF TERMINATIONS, SETTLEMENTS AND JUDGMENTS Page 5 3% if the employer failed to file an information return (Form 1099-MISC) for the worker with the IRS. The IRS penalty for unintentionally not withholding the employee's share of Social Security and Medicare taxes is 20% of the employee's share of the tax. The penalty is doubled to 40% if the employer failed to file an information return for the worker with the IRS. If an employer intentionally misclassifies the worker as an independent contractor, even after determining that an employer-employee relationship exists, the above penalties do not apply, and the employer is liable for the full amount of federal income tax that should have been withheld, and 100% of the employee's and employer's share of Social Security and Medicare taxes. An employer misclassifying workers will also be subject to state penalties. An employer that misclassified workers as independent contractors may have to retroactively pay employment benefits in addition to employment taxes. In 1996, a federal appeals court held that Microsoft Corporation, which had agreed to reclassify freelancers as employees after an IRS employment tax audit, also had to include the misclassified workers in its 401(k) plan and 423 employee stock purchase plan [Vizcaino v. Microsoft Corp., CA9, 78 AFTR 2d , 10/3/96]. Dead People's Wages. The Internal Revenue Service has a set of strange and confusing rules for tax withholding on a deceased employee s final paycheck. There are three relevant taxes that need to be managed: Federal income tax withholding, FICA tax withholding and FUTA tax. For Federal income tax withholding, the Internal Revenue Service states that no income tax withholding needs to be made on a deceased employee s final paycheck and the wages should never be reported as taxable income (box 1) on the employee s W-2 Form. Instead, the gross wages are reported on a Form 1099-MISC (box 3, miscellaneous income) issued to the estate of the decedent but only if the wages are $600 or more. In addition to issuing a 1099-MISC to the estate of the deceased employee, an employer is required to withhold, account for and pay FICA (both Social Security and Medicare, if applicable) and FUTA taxes on a deceased employee s final paycheck if the final paycheck is delivered in the same calendar year in which the employee died. In such case, the employee s W-2 Form for the year will include the final paycheck amount as gross wages for Social Security (box 3) and Medicare (box 5) purposes (nothing goes in box 1), subject of course to the Social Security wage limitation. Such inclusion will also increase the decedent s wage base for purposes of computing the surviving spouse s and dependent s survivor benefits for Social Security. If the final paycheck is delivered in a calendar year following the year of death, then no FICA or FUTA taxes need be withheld or paid by the employer. Clearly, this may present some planning opportunities for the employer and the estate. Assuming FICA taxes are substantial, the estate and the employer would be better off to postpone receipt of the decedent s final paycheck until the next calendar year, even though it may slightly reduce Social Security survivor benefits. Such a decision should be joint. If not a joint decision, an employer has an obligation to pay the decedent s last wages upon demand by the decedent s duly appointed executor or administrator. 699 Walnut Street, Suite 1600, Des Moines, IA Phone: Fax:

7 TAXATION OF TERMINATIONS, SETTLEMENTS AND JUDGMENTS Page 6 For further information on withholding and payment of taxes from a deceased employee s wages or salary, see Internal Revenue Service Revenue Ruling and instructions to Form W-2. Attorney Fees Paid Out of Judgment or Settlement Award. Until two recent events, plaintiffs receiving taxable judgment or settlement awards would direct the defendant to pay the plaintiff s attorney fees directly to the attorney from the judgment or settlement proceeds. The Second, Fifth, Sixth, Ninth and Eleventh Circuits held that attorney fees paid directly to plaintiff s attorney by the defendant was not gross income to the plaintiff. Raymond v. U.S. 91 AFTR 2d (D.C. VT 12/17/2002); Srivastava, Sudhir P. v. Comr, 220 F.3d 353 (5 th Cir. 2000); Clarks, Arthur L Estate v. U.S., 202 F.3d 854 (6 th Cir. 2000); Banaitis v. Comr. 340 F.3d 1074 (9 th Cir. 2003), cert. granted, No (S.Ct. Mar. 29, 2004); Foster, Mattie v. U.S. 106 F. Supp 2d 1234 (DC Ala. 2000). All the other circuit courts and the IRS held that the plaintiff was taxable on the entire judgment or settlement award with an offsetting deduction for the attorney fees. The deduction, however, was limited and in some cases completely unavailable due to the Alternative Minimum Tax. The first event that changed the legal landscape regarding the taxation of judgment or settlement awards was the enactment of the American Jobs Creation Act of The American Jobs Creation Act of 2004 provides that in cases of unlawful discrimination a plaintiff s attorney fees and costs may now be deducted by the plaintiff in calculating adjusted gross income (an above-the-line deduction). Codified at IRC 62(a)(20) & (e). The deductions may not exceed the amount includible in income by the plaintiff. Thus, the deduction will apply only in cases of unlawful discrimination in which the plaintiff received an award or a settlement of damages that are taxable to the plaintiff. The deduction would not apply if the damage award or settlement were nontaxable (such as awards on account of a personal injury) and would not apply if the plaintiff were not successful in receiving a damage award or settlement. The second event was a decision issued by the United States Supreme Court on January 25, In Commissioner v. Banks and Banaitis, 543 U.S. 426 (2005), the Court held that attorney fees paid to a plaintiff s attorney is taxable to the plaintiff regardless of whether the plaintiff is or is not entitled to a deduction for the attorney fees. The Court reasoned that the law of agency applies to such cases where the attorney is the agent and the plaintiff is the principal. The attorney, in his capacity as agent, is duty bound to act only in the interests of the principal and so it is appropriate to treat the full amount of the recovery as income to the principal. In summary, in all situations in which a judgment or settlement award is taxable, the plaintiff is required to include in taxable income the full amount of the judgment or settlement award. The plaintiff will then be entitled to an above-the-line deduction for attorney fees if the judgment or settlement award arose due to unlawful discrimination. In all other cases, the plaintiff will be entitled to a below-the-line deduction for attorney fees which may be limited by the alternative minimum tax or otherwise. If the settlement agreement between the plaintiff and defendant requires the defendant to pay the plaintiff s attorney fees directly to the plaintiff s attorney, two Form 1099-MISCs must be generated. The first will report the amount of attorney fees in Box 3, Other Income, and be issued to the plaintiff. The second will report the amount of 699 Walnut Street, Suite 1600, Des Moines, IA Phone: Fax:

8 attorney fees in Box 14 and be issued to the plaintiff s attorney. Treas. Reg (f); W:\DOCS\CLIENT\FIRM\DREPP\ DOC

9 Tax and Reporting Treatment of Judgment/Settlement Payments to Employees (reprinted from Chief Counsel Memorandum PMTA ) Tax and Reporting Treatment of Judgment/Settlement Payments to Employees Payment Character Income Taxable? Wages (FICA and ITW)? Reporting Requirement Back pay (other than Yes Yes 1 W-2 lost wages received on account of personal physical injury or physical sickness) Front pay Yes 2 Yes W-2 Dismissal/severance pay Yes Yes W-2 Compensatory or consequential damages paid on account of personal physical injuries or physical sickness Compensatory damages not paid on account of personal physical injuries or physical sickness (e.g., emotional distress) Consequential damages not paid on account of personal physical injuries or physical sickness Punitive/Liquidated Generally, no Generally, yes No None No 1099-MISC, Box 3 Yes No 1099-MISC, Box 3 Yes No 1099-MISC, Box 3 damages Interest Yes No 1099-INT, Box 1 (if $600 or more) Costs Yes No 1099-MISC, Box 3 Medical expenses Generally, No None no Overtime Yes Yes W-2 Restoration of benefits: Health Premiums, TSP employee and employer contributions, and retirement contributions To be determined To be determined To be determined Taxes employee income tax or employee Yes Yes. See Publication 15-A W-2

10 portion of FICA Travel if requirements No No No of 62(c) (accountable plan) are met Travel if requirements Yes Yes W-2 of 62(c) are not met 1 In the Eighth Circuit, back pay (and front pay) awarded for an illegal refusal to hire is not subject to FICA and income tax withholding. Newhouse v. McCormick & Co., 157 F.3d 582; 82 AFTR 2d (8 th Cir. 1998) (explaining that no employment relationship existed so character of the payment could not be wages ). 2 The Fifth Circuit holds that only back pay is subject to FICA and income tax withholding. Dotson v. U.S., (CA ) 78 AFTR 2d ( wages is compensation for services already performed, not for services that will not be performed). Tax and Reporting Treatment of Attorneys Fees Total Employer Payment Made Jointly to Attorney and Employee: Nature of Payment Income Taxable to employee? Employee Attorney Court award Yes attorneys Attorneys fees Box 14 of 1099 designating fees generally reportable in Box 3 MISC in the amount attorneys fees1 taxable to of 1099-MISC (not W-2). Treas. Reg (f)(1) and (2). of the check payable jointly to employee and attorney. Treas. Reg (a), and (f) Ex. 1. Court award without Yes attorneys The total award is Box 14 of 1099 designation of fees generally reportable, as MISC in the amount attorneys fees taxable to appropriate (on 1099-MISC or W-2). Settlement payment Yes attorneys fees generally taxable to To be determined, based on the nature of the action. If wages, reportable on W-2. If not wages, reportable in Box 3 of 1099MISC. of the check payable jointly to employee and attorney Treas. Reg (a), and (f) Ex. 1. Box 14 of 1099MISC in the amount of the check payable jointly to employee and attorney Treas. Reg (a), and (f) Ex.

11 Separate Employer Payments to Employee, and to Attorney for Attorneys Fees: Nature of Payment Income Taxable to Employee? Employee Attorney Court award Yes attorneys Attorneys fees Box 14 of 1099 designating fees generally reportable in Box 3 MISC to attorney in attorneys fees1 taxable to of 1099-MISC (not W-2) even though paid separately to attorney. Treas. Reg (f)(1) and (2). the amount of check payable to attorney. Treas. Reg (a), and (f) Ex. 3. Court award without Yes attorneys The total award is Box 14 of 1099 designation of fees generally reportable, as MISC to attorney in attorneys fees taxable to Settlement payment Yes attorneys fees generally taxable to appropriate (on 1099-MISC or W-2) even though attorneys fees paid separately to attorney. Treas. Reg (f)(1) and (2). To be determined, based on the nature of the action. If wages, reportable on W-2. If not wages, reportable in Box 3 of 1099MISC. 1 Workers rights statutes, such as Title VII, generally include fee-shifting provisions. Total Employer Payment to Employee: the amount of check payable to attorney. Treas. Reg (a), and (f) Ex. 3. Box 14 of 1099MISC to attorney in the amount of check payable to attorney. Treas. Reg (a), and (f) Ex. 3. Nature of Payment Income Taxable to Employee? Employee Attorney Court award Yes attorneys Attorneys fees None. See, e.g., designating fees generally reportable in Box 3 Treas. Reg. attorneys fees1 taxable to of 1099-MISC (not W-2). Treas. Reg (a), (d)(4), and (f) Ex (f)(1) and (2). Court award without Yes attorneys The total award is None. See, e.g., designation of fees generally reportable, as Treas. Reg. attorneys fees taxable to appropriate (on 1099-MISC or W-2) (a), (d)(4), and (f) Ex. 4.

12 Settlement payment Yes attorneys fees generally taxable to To be determined, based on the nature of the action. If wages, reportable on W-2. If not wages, reportable in Box 3 of 1099MISC. None. See, e.g., Treas. Reg (a), (d)(4), and (f) Ex. 4. Total Employer Payment to Attorney: Nature of Payment Income Taxable to Employee? Employee Attorney Court award under Yes attorneys Attorneys fees Total amount of check fee-shifting statute fees generally reportable in Box 3 reported on 1099 designated as taxable to of 1099-MISC (not MISC, box 14. Treas. attorneys fees1 W-2). Treas. Reg (f)(1) and (2). Reg (a) and (d)(4). Court award Yes attorneys The total award is Total amount of check without fees generally reportable, as reported on 1099 designation of taxable to appropriate (on MISC, box 14. Treas. attorneys fees 1099 or W-2). Reg (a) and (d)(4). Settlement Yes attorneys To be determined, Total amount of check payment fees generally taxable to based on the nature of the action. If wages, reportable on W-2. If not wages, reportable in Box 3 of 1099MISC. 1 Workers rights statutes, such as Title VII, generally include fee-shifting provisions. reported on MISC, box 14. Treas. Reg (a) and (d)(4).