Tredway, Lumsdaine and Doyle LLP

I frequently receive questions regarding the tax treatment of employment damage awards. At Tredway, Lumsdaine & Doyle, LLP we are ready to handle both the questions posed by employers as to how best to resolve disputes with current and past employees as well as advise these employers on the tax consequences of the actions they take. We stay current on both employment law issues and business tax issues to thoroughly advise our clients.

Below is an article from RIA Checkpoint analyzing a recent Chief Counsel Memo on these issues.

Chief Counsel Memo Explains Tax Treatment of Employment Related Judgments and Settlements

PMTA 2009-035

A recent Chief Counsel Memo (CCM) designated as PMTA (Program Manager’s Technical Advice) 2009-035, provides a detailed account of the IRS’s position on how to handle the income and employment tax consequences and reporting duties relating to employment related judgments and settlements. The CCM addresses the employment related judgments and settlements that the IRS may make to its current or former employees, but its conclusions (although they can’t be used or cited as precedent) are useful to any employer.

The CCM consists of a review of the various types of employment related judgments and settlements, along with a number of summary charts. Here’s a review of the more widely applicable topics covered in the Memo.

Severance pay. A payment made by an employer to an employee upon the involuntary termination of employment is taxable to the recipient. Under Reg. § 31.3401(a)-1(b)(4), payments made by an employer to an employee on account of dismissal, i.e., involuntary separation from the service of the employer, are wages for Federal Insurance Contributions Act (FICA) and income tax withholding (ITW) purposes regardless of whether the employer is legally bound by contract, statute, or otherwise, to make such payments. Severance pay is reported on Form W-2.

Back pay. This is compensation paid to an individual to compensate him for pay he 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 is illegally terminated by an employer, or to an applicant for employment who is not hired for illegal reasons.

Back pay (other than for lost wages received on account of personal physical sickness or physical injury) is taxable, subject to FICA and ITW, and must be reported on Form W-2. The CCM reiterates IRS’s rulings position that back pay awarded for an illegal refusal to hire is wages for federal employment tax purposes, but acknowledges the Eighth Circuit’s decision to the contrary in Newhouse v. McCormick & Co., (CA 8 10/2/1998) 82 AFTR 2d ¶98-6576. There, the Eighth Circuit (covering Minnesota, North and South Dakota, Iowa, Nebraska, Missouri, and Arkansas) held that FICA tax and ITW do not apply unless an actual employer-employee relationship existed.

The CCM notes that in U.S. v. Cleveland Indians Baseball Co., (S Ct, 4/17/2001) 87 AFTR 2d ¶2001-1706, the Supreme Court agreed with the IRS’s view that employment taxes on back wages are calculated with respect to the period during which the wages are actually paid, rather than the period during which the wages should have been paid.

Reporting back pay under a statute to the Social Security Administration (SSA). The CCM notes that there are special SSA reporting procedures for payments to employees of back pay under a statute. These procedures are described in IRS Pub. 957, Reporting Back Pay and Special Wage Payments to the Social Security Administration, and could apply in the case of an employee who received a back pay award in one year that related to several prior years in which the wages should have been paid. For social security benefit purposes only, and not for the computation of FICA tax, back pay is allocated to an individual’s earnings record in the period or periods in which the wages should have been paid. Back pay awarded under a statute is a payment by an employer pursuant to an award, determination or agreement approved or sanctioned by a court or government agency responsible for enforcing a federal or state law that protects an employee’s rights to employment or wages (e.g., Age Discrimination in Employment Act).

Front pay. This is paid to an individual to compensate him for pay he 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. The CCM says the IRS’s position is that front pay is wages for FICA purposes, and that most appellate courts addressing the issue have agreed. However, it notes that in Dotson v. U.S., (CA 5 1996) 78 AFTR 2d ¶96-5436, the Fifth Circuit (covering Texas, Louisiana, and Mississippi) held that only the back pay portion of a settlement was wages for FICA tax purposes.

Compensatory damages. If paid for physical injury or physical sickness, compensatory damages are excluded from income under Code Sec. 104(a)(2), not subject to payroll tax, and not reported on an information return. Also excluded are consequential damages (compensation for damage, loss, or injury that do not flow directly and immediately from the act of the party, but are consequences or results of such act) for physical injury or physical sickness. Compensatory damages not paid on account of physical injury (e.g., paid for emotional distress) are taxable and are reported on Form 1099-MISC, but are not subject to FICA or ITW.

The CCM notes that an amount paid for medical care on account of emotional distress is excluded under Code Sec. 104(a)(2) if the expense has not been previously deducted under Code Sec. 213, and is not wages for employment tax purposes.

Punitive/liquidated damages. In general, liquidated and punitive damages are not directly related to the actual loss incurred. Liquidated damages are amounts that parties agree to pay in the event of a breach of an agreement as a substitute for compensatory damages. Liquidated damages may also be imposed by statute (e.g., the Fair Labor Standards Act). Punitive damages punish the wrongdoer for wrongful conduct. The CCM notes that liquidated and punitive damages are income to the recipient and are reported on Form 1099-MISC, but aren’t subject to withholding.

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