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| Proper Taxing of Judgments and Settlements | ||||
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Imagine that a state employee brings an action against the employing agency for an alleged wrongdoing. Once the employee takes the necessary steps and the legal engine begins turning, four possible outcomes can result: the action is dropped, the employee loses in the action against the employer, the employer settles with the employee, or the employer loses and must statisfy a judgment entered in favor of the employee. If the employer wins or the employee drops the action, the employer does not have to be concerned with any tax consequences because no money changed hands from the employer to the employee. If the employer settles with the employee or loses an adjudication whereby the employer must satisfy a monetary judgment, employers must be aware of the tax requirements involved with that settlement or judgment. The first thing employers must know is that settlements and judgments are treated exactly the same when it comes to the tax consequences. Longino v. Comm, 32 TC 904 (1959). There are at least three categories of damages the employee may recover: physical injuries, nonphysical injuries, and back wages. Recovery of damages for physical injuries is not taxable income. Nonphysical injuries (which include interest, court costs, and attorney’s fees) are subject to income tax. IRC § 104. Recovery of back pay is subject to the same taxes as if it had not been held back. See U.S. Gilmore 372 US 39 (1963). Therefore, when back wages are paid as a result of a settlement or judgment, payments are subject to FICA, FUTA, state unemployment tax, state income tax, and federal tax withholding. Since the nature of recovery directly affects the taxing of settlement and judgment payments, employers must specifically allocate each dollar of recovery to its respective category of damages in either its settlement agreement or court order. Failure to allocate damages into categories will allow the IRS, in its discretion, to allocate damages or to treat the entire payment as back wages, Rev. Rul. 80-364. This reallocation or treatment by the IRS may result in additional employer liability, employee’s portion of FICA for the increased amount, plus penalties and interest, as well as employer liability for failure to withhold taxes, plus penalties and interest. Employers should use either of two methods to help determine allocation of damages. First, how the employee’s complaint allocates damages ultimately drives these methods of allocation. For example, a complaint claims a total dollar amount of $100,000 in damages. To reach that amount, the complaint claims $50,000 for back wages, $30,000 for physical injuries, and $20,000 for attorney’s fees. Therefore, 50% of the total amount goes to back wages, 30% goes to physical injuries, and 20% goes to attorney’s fees. This same percentage of allocation should be applied to the amount ultimately recovered by the employee whether through settlement or judgment. Second, if the employee’s complaint does not contain these specific allocations, the employer should determine a reasonable allocation based on the facts and circumstances surrounding the case. Employers should maintain a file containing any documentation that supports the allocation they have made. Again here, the IRS may reallocate in the settlement or judgment to be unreasonable. A reallocation by the IRS may result in additional employer liability. According to Rad Burch of Haynsworth, Baldwin, Johnson, and Greaves, once a reasonable allocation has been made, the settlement agreement or court order should include a provision that the employer will make all tax withholdings and file all tax forms as required by applicable state and federal tax law. The employer should report the back wages portion of the settlement on Form W-2. The employer should report all other taxable portions of the settlement on Form 1099, even the payments made to the plaintiff’s attorney. Alexander v. IRS, 77 AFTR2d96-301 (1st Cir. 1995); IRC § 6041; and instructions to Form 1099. In addition, under a new tax law, which became effective on January 1, 1998, the employer must send a Form 1099 for any payments made to attorneys or law firms IRC § 6045(f). Agencies should keep these tax considerations in mind both during preparation of a settlement agreement or court order and during the administration of the outcome. Handling settlements and judgments in the appropriate manner will help agencies limit their liabilities to those arising out of their relationships with their employees and eliminate the possibility of further liability at the hands of the IRS.
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| THE LANGUAGE USED IN THIS DOCUMENT DOES NOT CREATE AN EMPLOYMENT CONTRACT BETWEEN THE EMPLOYEE AND THE AGENCY. THIS DOCUMENT DOES NOT CREATE ANY CONTRACTUAL RIGHTS OR ENTITLEMENTS. THE AGENCY RESERVES THE RIGHT TO REVISE THE CONTENT OF THIS DOCUMENT, IN WHOLE OR IN PART. NO PROMISES OR ASSURANCES, WHETHER WRITTEN OR ORAL, WHICH ARE CONTRARY TO OR INCONSISTENT WITH THE TERMS OF THIS PARAGRAPH CREATE ANY CONTRACT OF EMPLOYMENT. |