Potential Tax Implications of Employment Settlements

Employee settlements are a fact of life for many businesses. The tax implications of those settlements, however, are too often an afterthought. Both parties involved should know the potential tax implications of employment settlements—understanding the tax treatment of settlement payments, their deductibility, and any reporting requirements can help both sides maximize benefits and avoid unnecessary taxes and penalties.

Understanding the Tax Treatment of Employment Settlement Payments

The tax treatment of an employment settlement largely depends on the origin and nature of the claims involved. For instance, if the claimant is suing for wages, the settlement recovery will be treated as wages. This means the amount received will be subject to the same tax considerations as regular income.

The IRS considers all payments for employment claims, including those allocated explicitly to attorneys’ fees, as part of the claimant’s income. This is a crucial point to note as it means that, even if the payment is made directly to the attorney, it will still be considered income for the claimant.

However, certain exceptions exist. For example, the IRS has ruled that payments for attorneys’ fees in specific class action lawsuits aren’t included in class members’ income where there’s no contractual agreement between the members and counsel. Similarly, the IRS has ruled that amounts representing attorneys’ fees paid to settle a lawsuit brought by a union against an employer to enforce a collective bargaining agreement aren’t included in the union members’ income.

Exclusions From Income

There are certain circumstances under which portions of these settlements could be excluded from a claimant’s taxable income. For example, a business owner paying the settlement might wonder whether paying out the settlement is something they can write off at tax time.

Under Internal Revenue Code Section 104, amounts paid to compensate for these damages are generally excluded from income. This type of damages isn’t subject to income tax, which can significantly reduce the claimant’s tax liability.

Like the cost of other business expenses, like equipment and travel, the costs from defending a lawsuit are usually considered costs incurred as part of doing business and are, therefore, tax deductible.

Similarly, if a claim involves a physical injury sustained at the workplace, compensation for that injury could be excluded from income. Regardless of the exact circumstances, the goal is to structure the settlement in the most tax-advantageous way possible. 

It’s important to note that these claims aren’t common in employment cases, typically involving wages, discrimination, or wrongful termination disputes. However, the potential tax savings can be significant when they do occur.

Moreover, applying these tax considerations can be complex and depends on each case’s specific facts and circumstances. Therefore, it’s crucial to consult with a tax professional or an attorney knowledgeable about these issues when negotiating and drafting employment settlement agreements.

Deductibility of Attorneys’ Fees

The tax considerations of an employment settlement don’t only concern the income received from the settlement; they also involve the expenses incurred during the process, such as attorneys’ fees. 

The claimant will generally be taxed on the entire settlement amount, including any portion paid directly to the attorney as fees. However, the Internal Revenue Code provides relief under Section 62(a)(20). Claimants are typically entitled to deduct attorney’s fees incurred in claims for unlawful discrimination and many other employment-related claims. These are “above-the-line” deductions taken directly from your gross income.

An “above-the-line” deduction is particularly beneficial because it reduces your adjusted gross income (AGI), which can potentially qualify you for other tax benefits. This differs from “below-the-line” deductions, which are taken from your AGI and subject to various limitations.

Suppose the attorneys’ fees aren’t deductible above the line. In that case, they may still be deductible as a miscellaneous itemized deduction on Schedule A. However, these deductions come with their own set of restrictions. For instance, they are only allowable to the extent they exceed 2 percent of adjusted gross income. Additionally, such deductions aren’t allowable for Alternative Minimum Tax purposes.

It’s important to note that the ability to deduct attorneys’ fees can significantly offset the tax burden of the settlement amount. This is a critical factor to consider when negotiating the settlement and determining the net benefit of any potential settlement amount.

Taxable Wages and Employment Taxes

All settlement payments regarding claims for severance pay, back pay, and front pay are considered wages for employment tax purposes. This means these amounts are subject to the same taxes as regular wages, including Social Security and Medicare.

The IRS asserts that attorneys’ fees for wage claims are wages subject to employment taxes unless the settlement agreement expressly provides an allocation for attorney’s fees. This can have significant implications for the overall tax liability of the settlement and should be carefully considered when drafting the settlement agreement.

Reporting Requirements for Settlement Payments

The tax implications of an employment settlement don’t end with the payment of the settlement amount. There are also important reporting requirements that both parties must adhere to to remain compliant with IRS regulations.

Employers, in particular, bear a significant portion of this responsibility. They’re generally required to file information returns for payments made on behalf of another person. This includes the entire settlement amount, even the portion paid directly to the attorney as fees. 

The total amount must be reported as paid to the claimant, regardless of how the payment is divided. This can be done using Forms W-2, 1099-MISC, or both, depending on the nature of the payments. For instance, if the settlement includes back wages, those amounts would be reported on a Form W-2. In contrast, other compensatory damages might be reported on Form 1099-MISC.

Failure to properly report these payments can result in significant penalties. Therefore, employers must understand these requirements and accurately report all settlement payments. As always, when dealing with complex tax matters, it’s advisable to consult with a tax attorney.

Proper evaluation of both the income and employment tax aspects of settlements and the correct reporting of settlement payments is critical to obtaining the best possible result. Failure to properly file a required information return or timely furnish the payee(s) with a correct Form W-2 and/or 1099-MISC may result in a penalty equal to 10 percent of the settlement amount. Therefore, it’s crucial to look before you leap and consider all tax implications before settling employment matters.

As a business law firm, we’re here to guide you through these complex processes and help ensure your business transition is as smooth and advantageous as possible. Contact us to discuss your options with confidence.

 

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