Resolving Employment Cases: Tax Implications for Employment-Related Settlements

In an era when settlement of employment cases is far more common than taking a case to verdict, reaching a settlement figure can seem like the end of the road. An informed litigator, however, keeps an eye on the client’s tax strategy to prevent unwanted surprises for the client after the settlement is reached.

Tax planning vis-à-vis settlements in employment matters is vital for two reasons: 1) an imprecisely worded settlement agreement can be challenged in tax court and lead to increased litigation costs, and 2) the characterization of damages affects whether the employer, or former employer, must withhold payroll taxes and pay a share of social security and other employment taxes. An employer client may find itself liable for an unpaid tax burden, interest, and penalties, depending on the facts of a specific case.

Liquidated Damages Clauses

Given the increasing frequency of post-employment litigation cases, employers often include a liquidated damages clause in employment contracts. One example of such an item is a confidentiality clause. The IRS does not consider liquidated damages to be wages of any kind. Such damages are reportable by an employer on a Form 1099, but no payroll withholding is necessary.

Physical Harm and Emotional Injury

As a matter of public policy, payments to make litigants whole for “injuries” or “sickness” are not reportable income, even if the recovery includes a component for emotional or psychological injuries. Settlements for pure emotional distress are taxable, even if there is a physical ailment connected to the distress, such as sleeplessness or stomach upset. Such payments must be reported on a Form 1099.

However, damages for emotional distress up to and including the amount expended by a plaintiff for medical care are not taxable or reportable. In this latter case, any payment in excess of medical costs are reportable on a Form 1099.

Back Wages and Lost Pay

Settlements for unpaid overtime, off-the-clock work, and breach of contract are generally taxable to the employee, and classified as wages to the employer. Such payments are reportable on a form W-2, and subject to withholding by the employer. This rule also includes lost future pay. The IRS considers the year in which a settlement payment is disbursed as the proper “tax year” to calculate withholding.
Miscellaneous Payments

Any unpaid interest payments for an employee are reportable as 1099 income, and are not considered wages. Punitive damages are also fully reportable as 1099 income, even if they are connected to a physical injury.

Finally, payments for a litigant’s attorneys fees are also reportable on a Form 1099.

Avoid Back Taxes, Penalties, and Interest

A settlement agreement between an employer client and a plaintiff should expressly spell out the allocation of the type of payments being made, even if the proceeds are disbursed as a single lump sum. If the parties execute the agreement in good faith, a tax court will typically find it to be binding. Also, an indemnity clause should be included in the settlement in most cases. Should the allocation be challenged, plaintiff will be liable for court costs, hopefully discouraging costly litigation.