Employment Tax Considerations for Businesses When Addressing Litigation with Employees or Former Employees

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1 Employment Tax Considerations for Businesses When Addressing Litigation with Employees or Former Employees William Hays Weissman Littler Mendelson, P.C. San Francisco, California It is a common fact of life that businesses get sued from time to time by employees and former employees. It is critical that businesses understand the potential employment tax considerations associated with such litigation, whether involving a settlement or judgment. Businesses that fail to understand the potential tax implications can find themselves liable for substantial taxes, penalties and interest when the taxing authorities come calling. This article provides a brief primer on the major employment tax considerations businesses should understand. Important Point # 1: The IRS and state taxing agencies are not parties to the litigation and therefore not bound by the parties or a court s determination as to the tax consequences of the litigation. The IRS and state tax agencies are not required to respect the tax consequences inherent in the settlement of litigation, and a settlement agreement s characterization or division of settlement amounts is not binding on the government. 1 Rather, the nature of the claim that was the basis for actual settlement, and not the validity of the claim, controls the characterization of the income for tax purposes. 2 Determination of the nature of the claim is primarily a factual question that is generally made by reference to the settlement agreement. 3 Inquiry is based on payor s intent or dominant reason for making payment. 4 Important Point # 2: A settlement agreement should specifically allocate amounts being paid based on the payor s intent in light of the facts and circumstances, and the amounts should be arrived at through arm s length, adversarial negotiations. In order for the allocation in a settlement agreement to be respected, it must be entered into (1) in an adversarial relationship; (2) at arm s length; and (3) in good faith. It is not enough for the parties to reach a settlement figure in an adversarial relationship; rather, the allocation must also be based on adversarial positions. For example, in Robinson v. Commissioner, following a jury verdict for about $60 million, including $6 million for lost profits, $1.5 million for mental anguish, and $50 for punitive damages, the parties settled for about $10 million. The plaintiff wanted to allocate 95 percent of 1 Hemelt v. Comm r, 122 F.3d 204, 208 (4th Cir. 1997); Vincent v. Comm r, T.C. Memo ; see also Treas. Reg. Section (a)-1(c). 2 Bagley v. Comm r, 105 T.C. 396, 406 (1995); Allum v. Comm r, T.C. Memo Robinson v. Comm r, 102 T.C. 116, 126 (1994). 4 Knuckles v. Comm r, 349 F.2d 610, 613 (10th Cir. 1965); Metzger v. Comm r, 88 T.C. 834, 847 (1987). 14

2 settlement to mental anguish (which was not taxable at the time). The court rejected the settlement allocation because it was not based on a reasonable allocation consistent with the claims alleged in the lawsuit. 5 Important Point # 3: It is necessary to understand what types of damages are available under the alleged causes of action. From a taxing agency perspective, the primary concern with respect to a settlement agreement involving an employer and employee is whether a reasonable amount of the settlement was allocated to wages, and thereafter that the correct amount of taxes were withheld and remitted. To the extent that there may be multiple allocations for non-wage (but taxable) payments, there is less incentive or interest for the taxing agency to address the matter with the employer because no employment taxes attached to such payments. The natural starting place for determining whether the allocation made in a settlement agreement is appropriate is the plaintiff s complaint. Certain claims and causes of action are only entitled to certain damages. For example, claims under the ADEA do not allow for tort type damages, and therefore no amount could be allocated to a claim under the ADEA for personal physical injury. 6 Once the claims and potential damages are determined, the relative strength of any claims should be reviewed. For example, a claim for back pay must be determined in light of whether the employee continued to be employed during the period at issue. Also, plaintiffs are obligated to mitigate their damages. Thus, it should be determined whether the employee obtained other employment, how quickly, and at what rate of pay. In at least some cases, despite claims for back pay, the facts may demonstrate that the employee lost little if any wages because he or she obtained other employment quickly for the same or a higher rate of pay. In such situations the amount of a settlement reasonably allocated to wages may well be small relative to other payments being made. Important Point # 4: Know the tax consequences of various forms of damages and how they apply to your case. After figuring out what forms of damages are available based on the causes of action in the complaint, it is then necessary to figure out the potential employment tax consequences of paying such damages. Below is a short explanation of the tax consequences of typical damages in litigation between employers or employees. A. Back pay claims All payments of wages are treated as wages subject to employment taxes unless specifically exempted, and no statute or regulation exempts back pay from the definition of wages for tax 5 See also Vincent v. Comm r, T.C. Memo Commissioner v. Schleier, 515 U.S. 323 (1995). 15

3 purposes. 7 This is true even if the workers receiving the payments are no longer employed by the payor for other purposes at the time the payment is made. 8 In Social Security Bd. v. Nierotko, 9 the United States Supreme Court held that back pay awarded under the National Labor Relations Act to an employee who had been wrongfully discharged was wages under the Social Security Act. The Court noted that the back pay constituted remuneration and also held that the remuneration was for employment even though the back pay related to a period during which the petitioner did not perform any service. 10 Nierotko has been cited in numerous case dealing with the question of whether payments upon settlement of claims constituted wages for employment tax purposes. 11 B. Emotional distress and personal physical injuries Under Section 104(a)(2) of the Internal Revenue Code of 1986, as amended (the Code ), amounts received on account of personal physical injury or illness are not income subject to tax. Prior to 1996, emotional distress was generally treated as falling within the exemption under Code Section 104(a)(2). However, for payments made after August 21, 1996, emotional distress was expressly carved out of Code Section 104(a)(2). The IRS has defined personal physical injury or sickness requires an observable bodily harm such as bruising, cuts, swelling and bleeding. 12 In contrast, emotional distress generally includes the physical symptoms of the emotional distress, such as stomach aches, ulcers, and headaches triggered by emotional distress. 13 Thus, it is important to understand that emotional distress is taxable income while personal physical injuries are exempt from taxation. Payments on account of personal physical injuries are not reported, while emotional distress damages are reported on IRS Form 1099-MISC, box 3 (other income) if over $600. Emotional distress is not taxable, however, up to the amount of any unreimbursed medical expenses actually paid by the plaintiff. Accordingly, when fashioning a settlement, it is useful to know if any medical expenses exist. Also, while emotional distress is taxable income, it is not wages because it is not intended to be in lieu of wages paid in employment. Therefore, it is not subject to employment taxes. C. Attorney fees 7 Code Section 3401; United States v. Cleveland Indians Baseball Co., 532 U.S. 200 (2001). 8 Treas. Reg. Section (a)-1(a)(5). 9 Social Security Bd. v. Nierotko, 327 U.S. 358 (1946). 10 Id., at E.g., Mayberry v. United States, 151 F.3d 855 (8th Cir. 1998); Hemelt v. United States, 122 F.3d 204 (4th Cir. 1997). The exception to this general rule is when the back pay is received on account of a personal physical injury or illness. E.g., Johnson v. United States, 76 Fed. Appx. 873 (10th Cir. 2003). 12 See IRS Private Letter Ruling Conference Committee Report to the 1996 Act. 16

4 Most settlements involve some form of payment of attorney fees. In two consolidated cases in 2005 the United States Supreme Court ruled that attorney fees are taxable income to the plaintiffs. 14 To the extent income is reported to an attorney, such income is reported on Form 1099-MISC generally in accordance with Code Section 6045(f). 15 Congress alleviated the problem of plaintiffs being taxed on attorney fees in most employment related litigation in the JOBs Act of Under the Act a plaintiff may take a deduction for attorney fees paid for discrimination cases that is above-the-line, making it potentially tax neutral, but only up to the amount of the settlement award. 16 This provision is only effective for payments made after October 22, In Revenue Ruling , 18 the IRS explained the income tax and employment tax consequences of interest and attorney fees being awarded by a court in connection with claims for back pay. Specifically, it stated that interest and attorney fees are generally not wages to the employee unless there is no specific allocation. These same principles would apply to settlements. D. Liquidated damages and interest Liquidated damages, such as those available under the Fair Labor Standards Act, and interest are treated as taxable income but not wages. 19 Important Point # 5: Document the efforts taken to determine the allocations being made. A reasonable allocation that is clearly specified in a settlement agreement is most likely to be respected, particularly when there is evidence to establish the reasons for the allocation. 14 See Banks v. Commissioner, 543 U.S. 426 (2005). Whether attorneys fees are income to a plaintiff under a fee shifting statute is unsettled (the Supreme Court in Banks declined to address the issue) and may depend upon state law. For example, under California law, when there is no contract providing for the disposition of such fees, they belong to the attorney that earned them. See Flannery v. Prentice, 26 Cal. 4th 572 (2001). This would suggest that attorneys fees under a fee shifting statute are not income to the plaintiff. Nonetheless, there is no truly definitive law to date on this issue from a tax reporting perspective. 15 See also Treas. Reg. Section Code Section 62(a)(20). For example, parties settle a discrimination case for $100,000 in damages to plaintiff and $125,000 in attorneys fees. Plaintiff would have $225,000 in gross income, but a $125,000 above-the-line deduction, resulting in net taxable income of only $100,000, the same amount as she actually receives. 17 There is also currently an administrative exception to the rule that attorneys fees are income to the plaintiffs in class action settlements. This exception is based on an IRS memorandum. While the legal justification for IRS position is somewhat suspect, because it benefits taxpayers it has not been challenged. See Office of Chief Counsel Memorandum, PRENO , May 18, Thus, to the extent that any settlement is a claims made settlement, it should be possible to exclude the attorneys fees from inclusion in income for the plaintiffs. However, this is subject to change at the IRS s discretion. 18 Rev. Rul , C.B. 294, I.R.B See, e.g., 2008 Form 1099-MISC Instructions, p. 4 (liquidated damages under ADEA not wages); Rev. Rul (liquidated damages are not wages subject to employment taxes); Kern v. Mid-Continent Petroleum Corp., 63 F. Supp. 120 (N.D. Iowa 1945), aff d 157 F.2d 310 (8th Cir. 1946) (liquidated damages under the FLSA are not wages for employment or income tax withholding purposes); 2008 Form 1099-INT (interest income); Rev. Rul (interest is not wages subject to employment taxes). 17

5 The reasons for payment - based on whatever investigation has been done - should be documented by the company for future use. Doing so will help in any audits of the settlement agreements. The IRS has now made audits of settlements a routine part of general corporate income tax and employment tax audits. Thus, for example, if an investigation reveals that a plaintiff claiming harassment visited a psychologist several times over the ordeal, it may support the company s decision to pay an amount for emotional distress or other compensatory damages relating to the harassment claim. Such evidence should be documented as part of the decision to allocate amounts to such damages. Nonetheless, there is no bright line test for determining the reasonableness of an allocation. Often the amount of any settlement is less than the potential damages that could be awarded under one cause of action, let alone the entire complaint. This is particularly true when dealing with claims of labor code violations (e.g., wage and hour violations) on a class action basis. Thus, it becomes most critical to make sure that the negotiations process is well documented and conducted in an adversarial arm s length manner. This, more than any other factor, is likely to establish that the allocations were reasonable in nature. Important Point # 6: If you cannot settle the matter, make sure you get jury instructions that take into account the tax consequences. Assuming that settlement does not occur, it is a good idea to get jury instructions that point out that any amounts awarded to an employee are subject to deductions as required by law. Thus, if a jury awards $50,000 in back wages, such amount should be minus applicable taxes. Important Point # 7: Think about the tax consequences before settling the matter and not afterwards. It is not uncommon for parties to agree to settle litigation at the end of a long day of mediation for a lump sum, and then afterwards look around to figure out what to do with it. It is a much better practice to consider the potential employment tax consequences before reaching that figure, and even better to negotiate each allocation separately. Doing so will help ensure the reasonableness of all allocations and that the settlement is respected by the taxing agencies. 18

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