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April 02, 2024
Navigating the Minefield: Hidden Taxation, IRS Reporting in Employment Settlements

by Shannon S. Pierce and Stephen A. Good

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Many businesses are familiar with the reasons that drive settlements in employment lawsuits. Even in cases when the facts generally support the employer’s version of events, practical considerations, such as avoiding the time and cost of protracted litigation, often lead businesses to reach reasonable settlements with former (or even current) employees. So, the lawyers and their clients put down their proverbial swords, and they get to work on drafting a written settlement agreement. What’s often overlooked in this process, however, is the taxation of the settlement payments. Here are some key issues to consider before signing a final settlement agreement.

Taxation of Settlements, Generally

Settlement payments are almost always taxable to the recipient, particularly in the context of an employment lawsuit.

If some or all of the settlement proceeds are attributable to alleged lost wages, then the business is obligated to withhold income and employment taxes as required by law and issue a Form W-2 to the employee (or former employee) for that portion of the payment.

Emotional Distress Versus Actual Physical Injury/Sickness

Often, under a misguided belief taxation can be avoided, counsel for the settling employee will attempt to characterize the settlement payment as being attributable to “compensatory damages,” “emotional distress,” or something similar. Here, again, a more precise analysis is needed to determine whether the settlement proceeds constitute taxable income to the employee.

If a portion of the settlement is intended to compensate the recipient for actual physical injury or physical sickness and there’s evidence in the record the employee truly did experience actual physical injury or physical sickness, then they may be able to exclude that portion of the payment from their taxable income.

When the alleged harm is emotional distress, however, the exception to taxation doesn’t apply. This is true even when the emotional distress manifests in physical symptoms such as insomnia, headaches, and stomach disorders. Consequently, when the alleged harm being settled is attributable to emotional distress and/or the physical manifestations of such emotional distress, the payment allocable to that alleged harm is taxable to the recipient.

From the perspective of the employer, two key points are worth noting:

First, in discussing potential taxation issues with the employee’s counsel, you should be mindful of the underlying litigation record. If the employee’s lawsuit asserts emotional distress and either doesn’t claim actual physical injury or physical sickness or the record is devoid of any real evidence of actual physical injury or physical sickness, then you could find yourself in hot water with the Internal Revenue Service (IRS) and/or the courts if you agree to contractual language suggesting the settlement proceeds won’t be taxable or you agree not to file a required information return (e.g., a Form 1099 or Form W-2) reporting the payment to the IRS.

Second, although finding common ground on key settlement terms is necessary to ensure the settlement becomes finalized, there’s no obligation that you and the employee reach consensus on the issue of how settlement proceeds will be taxed. Instead, your obligations regarding the nonwage portions of employment settlements are limited to information reporting.

Thus, when the nature of the alleged harm isn’t unequivocally the existence of actual physical injury or physical sickness, you should put the employee on notice that you can’t agree to their preferred tax treatment and ensure the settlement agreement either is silent on the issue of taxability or includes language confirming that no agreement about taxation has been reached.

Attorneys’ Fees Are Taxable to the Employee, Not Just the Attorneys

Settlement discussions can also derail if the parties and their counsel are unaware of the rules governing the reporting and taxation of attorneys’ fees. Many times, counsel for the employee will request that a portion of the settlement proceeds be paid directly to counsel rather than to the employee under a misguided belief that this will prevent the employee from being taxed on that portion of the settlement proceeds.

IRS regulations and supporting case law are clear, however, that payments made to an employee’s attorney are included in the employee’s gross income (in addition to being included in the counsel’s gross income):

In the case of a litigation recovery the income-generating asset is the cause of action that derives from the [employee’s] legal injury. The [employee] retains dominion over this asset throughout the litigation. . . . The attorney is an agent who is dutybound to act only in the interests of the principal, and so it is appropriate to treat the full amount of the recovery as income to the principal.

You Should Report All Settlement Proceeds, Taxable or Not, to the IRS

Employers are required to report to the IRS (on either a Form W-2 or a Form 1099-MISC) settlement payments that are made to employees or former employees. Failure to comply with the mandatory reporting obligations can yield significant penalties for the employer, including a penalty equal to the greater of $500 (indexed to inflation from 2016) or 10% of the aggregate dollar amount of the items required to be reported correctly.

Given the potential ramifications, you should err on the side of reporting all settlement payments, regardless of whether you and the employee reach consensus about the tax treatment of such payments.

Additionally, when settlement proceeds include payment to the employee’s counsel, the employer should include the amount of that payment in a Form 1099-MISC or Form W-2 not only to the counsel but also to the employee directly. While this may, at first blush, appear as double reporting, this seemingly duplicative reporting is mandatory.

Takeaway

The taxation of settlement proceeds is a complex minefield for employees and employers alike. In settling employee disputes, you should consult with competent employment and tax counsel to ensure compliance with applicable rules.

Shannon S. Pierce and Stephen A. Good are attorneys with Fennemore Law. Shannon practices primarily in the areas of employment defense and commercial litigation. Steve assists clients with structuring their businesses and negotiating commercial transactions, with an emphasis on advising clients regarding the associated income, estate and gift tax implications. You can reach them at spierce@fennemorelaw.com or sgood@fennemorelaw.com.

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