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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When you hear news of possible corporate tax rate increases, your first thought may be how this will hurt your company’s bottom line. In addition to concerns about reduced profits, you might wonder how changes in taxation laws affect stock market prices. In many cases, stock prices go up after a federal tax increase. Still, many worry about what will happen if the economy stalls.
Business owners do not have much influence over tax laws. They do have choices about reducing their tax burden. For example, selling stocks is taxable. Smart stockholders know the ins and outs of capital gains, tax credits, and taxes on dividends. Knowledge of tax laws related to the sale of stocks is especially important for those looking to sell their businesses.
The History of Taxation Laws Affecting Stock Market Prices
President Joe Biden’s 2024 budget proposal includes an increase in the corporate income tax from 21% to 28%. Although the proposed tax hike is sizable, if passed the corporate tax rate will still be lower than the top rate of 35% corporations paid before 2018. Congress is unlikely to approve new corporate tax laws, but the president’s proposal has reignited dialogue on corporate tax rates.
The last corporate tax hike was in 1993, when the government raised the rate from 34% to 35%. The tax rate stayed the same until Congress passed the 2017 Tax Cuts and Jobs Act and lowered the corporate tax rate to the current 21%. Most corporations and their taxation law experts find ways to pay the government less than the statutory tax rate. The effective federal tax rate for large corporations decreased from 16% in 2014 to just 9% a year after the 2017 tax cuts.
Despite what one would think, markets have had strong returns following tax increases over the past 50 years. Fidelity compared tax increases with stock market trends from 1950-2021. The study included corporate, personal, and capital gains tax increases. Key findings include:
- The S&P 500 index had higher than average returns after tax increases 13 times.
- Stocks rose every time the corporate tax rate increased.
The study’s findings are interesting, but Fidelity does not have enough information to draw a conclusion about how taxation laws affect stock market prices. When corporate taxes have increased and stock prices also went up, the economy might have been stimulated by factors such as job growth, defense spending, or low interest rates. The added sales revenue from a booming economy often give companies what they need to counter higher taxes and come out ahead.
Selling Stocks Is Taxable Under Capital Gains Laws
While you cannot affect stock market prices or tax increases, you can reduce your tax liability related to selling stocks or your business. The Internal Revenue Service levies capital gains taxes when you sell stocks:
- Long-term capital gains taxes apply to the sale of assets when you have owned a business for one or more years. Long-term capital gains have lower tax rates than other sources of income. The three tax rates are income-based: 0%, 15%, or 20%.
- Capital gains for businesses less than one year old are taxed at ordinary income tax levels.
To figure the taxable gain of the sale of your pass-through entity, subtract the seller’s basis from the purchase price. The proceeds will be taxed as capital gains.
Tax Laws Related to Selling a Business
Before getting serious about the potential sale of your business, find out how the structure of a sale will affect both your federal and state taxes. Failure to structure the sale properly may have a significant impact on your tax bill, and hence on your retirement fund.
The sale of a business usually is classified as a long-term capital gain for which the seller is responsible. The long-term nature of the gain adds up. If you started your business 15 years ago with $75,000 and are selling it for $5 million, your capital gain is $4.25 million. In this example, a federal capital gains tax at a 20% rate is $850,000.
Businesses may be sold in one of two ways: As a stock offering or a sale of assets. Most sellers prefer stock sales while buyers want to buy the assets. The seller will pay capital gains taxes.
Strategies for reducing taxes when selling stock differ by corporate structure. The owners of pass-through entities—Limited Liability Companies (LLC), partnerships, or S Corporations—usually sell their personal stock shares to transfer the company to a new owner. They pay capital gains taxes on their personal income taxes and the company does not owe additional taxes.
A buyer may be adamant about buying the assets of a pass-through entity, not stock, because of the tax advantages for them. The seller can go ahead and sell the assets and not worry about paying any taxes beyond capital gains.
In contrast, selling assets instead of stock has negative consequences for owners of C Corporations. When a company sells its assets, it must pay taxes at both the corporate and shareholder level. If the shareholders sell their stock, they receive a direct payment and pay capital gains tax. Sellers often need help from a taxation attorney to negotiate with buyers for the deal that is in their best interest.
Taxation Attorneys Help Business Owners Cut Their Tax Burden
If you are planning to sell your business, ask for advice from taxation attorney Christopher Swiecicki. He helps business owners design an exit strategy with the lowest tax burden possible. Some tactics Christopher recommends include:
- Spread out your tax liability. You can ask the buyer to pay in installments to eliminate your need to pay all the capital gains taxes in one year.
- Watch the calendar. Do not sell a business before it is at least a year old to benefit from the lower rates of capital gains taxes.
- Do not rush into a sale. Negotiate with confidence when the buyer wants to make a deal that works for them but not you. Take your time and stand your ground.
- Reinvest in the Opportunity Zone Fund. You can defer capital gains tax through December 31, 2026, by investing capital gains from the sale of a business into an Opportunity Zone, a federal economic development program. The investment must be made within six months of the capital gains.
Selling your business may be the largest financial transaction you will ever make. Feel confident you are structuring the sale to minimize capital gains taxes with help from taxation attorney Christopher Swiecicki. Call our office at (636) 778-0209 to arrange a free consultation.
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Investing in emerging fields like tech and software can have enormous tax advantages. When entrepreneurs sell their businesses, they may be able to exclude up to 100% of capital gain under Section 1202—up to $10 million or 10 times their investment, whichever is more. Both founders and their investors qualify for the exclusion after they have owned the company for five or more years.
If you want to position yourself for the Section 1202 gain exclusion when you sell your business, you may need to change the structure of your business to make an easy sale.
Requirements for Claiming a Section 1202 Gain Exclusion
When selling a business or stock, having the wrong structure can be incredibly costly. For example, selling a business after changing the organizational structure from a C Corporation to a trust disqualifies the seller from the Section 1202 gain exclusion.
To qualify for the exclusion, a small business must meet the following requirements:
- Its aggregate gross assets did not exceed $50 million at any time on or after August 10,1993, and before the issuance.
- Its aggregate gross assets do not exceed $50 million after the issuance.
- It is a U.S. C Corporation and will continue to be so when its stock transfers to a buyer.
- The owner bought its stock with cash, property, or services.
- Its stock must be stock as defined in the federal income tax code. Non-vested stock, stock options, and warrants are not Q.S.B.S.
While corporate stockholders are ineligible for Section 1202’s gain exclusion, stockholders of other business entities may qualify for the gain exclusion. This includes individuals, trusts, and pass-through entities.
Which Business Investments Qualify for Capital Gain Exclusions?
The capital gain exclusions in Section 1202 were designed to stimulate the economy. Thus, qualified trades or businesses are those creating jobs and/or knowledge including manufacturing, technology, research and development, and software.
Investments in service industries are not qualifying stock purchases. Section 1202 lists the following fields as not qualified for the capital gain exclusions:
A. Accounting, actuarial science, athletics, brokerage services, consulting, engineering, financial services, health, law, performing arts, or any other profession in which the main asset is the reputation or skill of employees.
B. Banking, financing, insurance, investing, or other financial services.
D. Oil and gas production covered under Section 613 or 613A.
E. Operation of hotels, motels, restaurants, or similar businesses.
In addition, property management is not a qualified business (Section 1202(e)(7)).
When you are structuring a business for easy sale and positioning yourself for capital gain exclusions, stay focused on its qualifying mission. You need to invest at least 80% of the corporation’s assets (by value) in qualified business activities to receive the Section 1202 exclusion.
How the Section 1202 Exclusion Became So Lucrative
The federal government sweetened the deal for investors following the Great Recession. Before 2009, Section 1202 allowed certain small businesses and start-ups to exclude 50% of capital gain in their gross income. The 2009 Recovery Act increased the exclusion to 75% of the capital gain of the sale of qualified small business stock (Q.S.B.S.) purchased between February 18, 2009, and September 27, 2010. The exclusion expanded to 100% of capital gain after September 27, 2010. Today, those selling a qualifying business receive:
- 100% exclusion from U.S. federal capital gain tax. (Sometimes the exclusion is a lower percentage. See below.)
- 100% exclusion from the alternative minimum tax
- Exclusion from the 3.8% net investment income tax
When you sell a business that does not qualify for Section 1202 exclusions, you probably will be responsible for paying the taxes on gains related to selling small business stock at the maximum rate of 28.7%.
Section 1202 Considerations for the Easy Sale of a Business
When you are ready to cash out on the successful launch of your business, pay close attention to whether your business is structured for easy sale AND for keeping you eligible for Section 1202 gain exclusions. To qualify for the exclusions, you must sell stock, not assets (deemed or actual). However, most buyers want to buy your company’s assets, not your stock. When you offer stock, and the other party is buying most of the shares, they will likely demand a discount. In this scenario, you may benefit from rolling over 20% to 30% of your equity as part of a structured deal. You will be allowed to defer gain, and be positioned to claim a Section 1202 gain exclusion, when the buyer eventually sells the rollover equity.
Many other ways to structure a business for easy sale are buried in the tax code. Here at Swiecicki & Muskett, we are experts at uncovering the opportunities lying just under the surface of the mountains of rules enforced by the I.R.S. and the court system.
Moves for When You Don’t Qualify for Section 1202 (Yet)
Suppose you want to take advantage of the Section 1202 exclusions but can’t because you have the wrong business structure. If you expect significant appreciation of your company’s stock and plan to sell your business or stock, changing your structure from an S corporation to a C corporation is a wise move. Capital gain after the conversion will qualify for exclusion on Section 1202.
The corporate tax team at Swiecicki & Muskett has many other solutions for structuring your business for an easy and lucrative sale. Based in St. Louis County, Christopher Swiecicki and his team serve growing businesses of all structures and sizes. Contact him at 636-778-0209 or email Chris@SwiecickiLaw.com.
A day barely goes by without a news report about some corporate entity making a serious misstep that has them facing fines and penalties. Several cases of corporate litigation come to mind: Lawsuits against the tobacco industry and big pharma are probably the most publicized. And there are cases of environmental harm by manufacturers, public utilities, or most recently, railroad accidents impacting both the land and the communities that live there.
While most of these companies do not mean to cause harm, there is little argument that they do bear some responsibility for their part in certain outcomes. It is no surprise when a government entity like the EPA imposes fines, or when a trial results in a court-ordered settlement for compensatory or punitive damages.
When a company makes a mistake (or breaks the law,) the CFO and the rest of the C-Suite understand that they must pay the penalty imposed. There can be a silver lining though: Some portions of the payment may be tax deductible. But the ability to take advantage of the deduction depends on the structure and wording of the settlement agreement. This is why it is essential to bring in skilled counsel like Swiecicki & Muskett Attorneys at Law early in the process. A combination of expertise in both taxation law and corporate litigation is necessary to make the best of a bad situation.
Paying a Corporate Settlement for a Mishap
Disasters like the collapse of the Taum Sauk Reservoir in Missouri in 2005 or the Norfolk Southern derailment in Ohio in 2023 result in environmental issues and incur large settlements paid to government entities. While a corporation will negotiate to reduce the amount of their fines and penalties, if possible, they have no choice but to pay up once everything is settled.
But consider this: Say a settlement calls for payment due to the government of $10,000,000. But what if that amount is tax deductible at a 35% tax rate? This means a tax deduction of $3,500,000, or in other words, a net cash outflow of $6,500,000 instead of the full $10,000,000.
This is still a very large number, of course, but the reduction is significant. And for a smaller company, the difference between paying the full amount of a settlement with or without a tax deduction can mean the ability to make payroll, or even keep the doors open.
It is extremely unlikely, if not impossible, that an entire settlement would be tax deductible as in the example above. There are strict requirements for which portions are, and which are not, deductible. Furthermore, the settlement must be structured properly from the start; there is no going back to claim a deduction after the fines are paid.
Any company finding itself subject to fines and penalties can improve its outcome with a corporate tax attorney who understands the IRS rules and can structure the settlement appropriately.
What is Deductible After a Catastrophe?
Understanding the tax treatment of fines and penalties paid by corporations requires in-depth knowledge of Internal Revenue Code Section 162(f). A typical accounting department or even corporate counsel might not have the experience in both tax and litigation to unravel the complex rules surrounding the topic.
IRC Section 162(f) dictates that in general, a tax deduction is not allowed if the company violated any law. The exceptions to this are compensatory amounts paid for “restitution, remediation, or to come into compliance” with a law.
This means that if the taxpayer (the corporation that paid the fine or penalty) can establish that the money paid went toward correcting or remedying the situation, it might be able to be claimed as a deduction. So, if the money is restitution to those who were harmed, remediation of damaged property, or helps the company come into compliance with the law, it could be eligible.
- Repayment of embezzled funds, for example, falls under the category of restitution, so could be claimed as a tax deduction.
- If the corporation must reimburse the government for the costs to investigate or litigate, those amounts are not restitution, remediation, or to come into compliance, and are therefore not allowable as a deduction.
There are many other compensatory amounts involved in a corporate settlement that a corporate litigation attorney may or may not be able to make an argument for as deductible. This is why finding someone who specializes in these cases is so important.
Structuring the Settlement for the Best Outcome
A tax deduction is not just an accounting trick; it is cash back in the pockets of a corporation after paying a large sum. That cash can help lessen the blow to a company and its shareholders after a disastrous and expensive event.
In order to maximize the tax benefits of a settlement with a government entity, corporations must act fast to bring in legal counsel to help draft the agreement. The calculations and verbiage built into the document will determine the end result.
An experienced tax attorney will be able to differentiate the funds paid into different “buckets.” There are amounts that will be clearly either compensatory or non-compensatory. Then there are dollars that are subject to interpretation. It is here where a firm like Swiecicki & Muskett excels, finding ways to categorize expenses that will present a viable argument for the IRS.
The IRS can and typically will dispute claims that are not clear-cut. Settlement agreements that are drafted properly with the correct legal language and phrasing can stand up to the challenge.
No corporation is happy about making a mistake that causes damage or hurts people or the environment. And when accidents happen, they understand that there will be a price to pay. But understanding the tax implications of a corporate lawsuit can lessen the blow.
When deciding the best way to structure their business, owners are often inundated with advice. And while friends , colleagues, and even accountants can mean well, they can inadvertently steer them into a choice that is problematic and expensive.
In the St. Louis area, we are lucky enough to have one of the nation’s best law schools. Washington University School of Law is one of these institutions and its rankings and numbers are currently at an all-time high being ranked 17th and the 1L class was top 10 in the nation. As a native St. Louisian and member of the law community, it’s my honor to work with and support the Washington University Law School program in several capacities.
For 9 years, I’ve served as an adjunct professor for Washington University. Throughout this time I’ve taught courses on Corporations, Business Acquisitions, and Tax, and every year I find more truth in the phrase “the more I teach the more I learn.” The intellect of the students and the tenured faculty are some of the finest in the nation. To ensure more students are able to pursue their interest in law at Washington University, I serve as Chairperson of the Law School Eliot Society. Our group works in conjunction with the university’s advancement department to increase giving and organizing special events for the alumni that give at the Eliot Level. Additionally, I’m honored to annually support the Christopher S. Swiecicki Scholarship at the Law School. This is an annual scholarship for a law student that has an interest in tax law.
Being able to assist the Law School and its students is simply a privilege and I look forward to continuing to support Washington University’s Law School and help impact the future of the law school.