Settling a Lawsuit with an Employee or Former Employee? Don’t Forget the Tax Consequences

by Butler Snow LLP

The IRS recently issued guidance that may be of particular interest to anyone with employees or former employees. In a Legal Advice issued by Field Attorneys (LAFA 20133501F), the IRS explained the tax treatment and reporting requirements with respect to attorney’s fees paid by an employer pursuant to a settlement agreement with former employees and the potential penalties that may apply to the employer for failing to report the payment(s) properly.

The former employees in this particular LAFA alleged violations of the Age Discrimination in Employment Act (ADEA), the Americans with Disabilities Act (ADA) and Title VII of the Civil Rights Act (Title VII). The employer made a variety of payments in settling these claims including: wages, tort damages, reimbursements of medical costs and attorney’s fees. During the IRS’s audit of the employer, it determined that the employer erroneously reported certain settlement payments to its former employees on Form 1099-MISC instead of Form W-2.

The LAFA explained that analyzing the correct treatment of employer settlement payments is a four-step process:

(1) determine the character of the payment and the nature of the claim that gave rise to the payment;

(2) determine whether the payment constitutes an item of gross income;

(3) determine whether the payment is wages for employment tax purposes; and

(4) determine the appropriate information reporting for the payment and any attorney’s fees (Form 1099-MISC and/or Form W-2).

If a claimant receives a payment that is includible in income (e.g., not damages for personal physical injury or physical sickness), any amounts allocated as part of a settlement or judgment to attorney’s fees are also includible in the claimant’s income, even if such amount is paid directly to the attorney.Such treatment also applies in the context of fee-shifting statutes.

The LAFA states that the IRS’s position is that payments constituting severance pay, back pay, front pay are wages for employment tax purposes.2 When attorney’s fees are clearly designated as such in a settlement agreement or by a court in a judgment awarding back pay, the attorney’s fees are includible in the claimant’s income, but NOT wages for employment tax purposes. However, if the settlement agreement or the judgment does not make a distinct allocation of the attorney’s fees and the claimant pays the attorney out of his/her recovery, the entire recovery, including the amount paid to the attorney, constitutes wages for employment tax purposes.

Of perhaps most significance to employers, the LAFA addresses the employer’s tax reporting obligations. Specifically, the LAFA concludes that when a settlement payment that includes attorney’s fees is included in the claimant’s taxable income, the employer must report the entire amount of the settlement payment on an information return (or returns, as the case may be) with the former employee as the payee, even if the check for the attorney’s fees was issued directly to the attorney. For settlement payments to employees (current or former), Form W-2 is the appropriate form to report payments treated as wages for employment tax purposes (i.e., severance pay, front, pay, back pay, etc.); whereas, Form 1099-MISC is the appropriate form to report the attorney’s fees includible in the former employee’s income if there is a clear allocation of the amount of the attorney’s fees because, as noted above, such amount is not considered wages for employment tax purposes. Thus, the employee would receive a Form W-2 and a Form 1099-MISC from the employer in such case. But if the settlement agreement does not specify the allocation of the attorney’s fees, such fees are considered wages subject to employment tax and included in the amount reported on Form W-2. The employer also reports the attorney’s fees on a separate Form 1099-MISC furnished to the attorney.

The LAFA provides three examples to illustrate the foregoing, which can be found here.

For employers, the key takeaway points from this LAFA and the examples above are two-fold. First, determining the correct amount to report on either Form W-2 or Form 1099-MISC in connection with the payment of an employment-related claim requires careful analysis.  Second, failing to file and furnish a required information return or filing an incorrect information return can subject the employer to penalties. In negotiating settlements for employment-related claims with employees and former employees, employers should not only be mindful of the information reporting requirements, but also understand how such reporting affects the claimant.

[1]  Attorney’s fees includible in the claimant’s income, however, may be deductible either (a) above-the-line to the extent allocable to “unlawful discrimination”, which includes an act that is unlawful under the ADEA, ADA and Title VII, or (b) below-the-line as miscellaneous itemized deductions, subject to the 2% of adjusted gross income floor.

[2]  Rev. Rul. 80-364, cited by this LAFA, provides guidance concerning the income and employment tax consequences in three situations in which amounts paid by an employer as a result of litigation are partially used for attorney’s fees.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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