Tax Issues Related to Settling Employment-Related Claims

By Jeffrey D. Davine

Unfortunately, just about every employer has to deal with claims made by employees or former employees. These claims can be for a variety of alleged “wrongs” such as failing to pay overtime, age discrimination and sexual harassment. In most cases these matters are resolved between the parties without a trial.

When resolving an employment-related claim and making a payment to an employee or former employee, it is important for the employer to ensure that it satisfies its income and employment tax withholding obligations. Failing to do so could subject the employer to a significant tax liability.

Unless the payment by the employer to the employee or former employee is being made on account of a physical injury or physical sickness where it can be shown that there is actual physical harm (such as bruises, cuts, broken bones, or similar injuries), the payment by the employer will be taxable to the employee or former employee. It is important to note that emotional distress (and all of the physical manifestations of emotional distress such as headaches, stomachaches, anxiety, and insomnia) is NOT considered to be a physical injury. If a payment is made that is taxable, the employer must carefully analyze its income and employment tax withholding obligations.

In general, if an amount is being paid by an employer that is designed to compensate the employee or former employee for a wage-based claim (such as a claim for unpaid overtime or back wages), the employer must treat the payment as a wage. This means that the employer must withhold and remit to the requisite taxing authorities (such as the IRS and the CA Employment Development Department) all of the “usual” income and employment taxes that are required when a wage is being paid. This also means that the employer is required to report the payment (and the taxes withheld) on an IRS Form W-2.

On the other hand, if an amount is being paid by an employer that is designed to compensate the employee or former employee for a claim that is not wage-based (such as a claim for age discrimination or harassment), although the payment is a taxable one, withholding of income and employment taxes is generally not required. The employer, however, may be required to report the payment on IRS Form 1099.

It is also important for an employer to understand that if, as part of a settlement, it is required to pay attorneys’ fees to the employee or former employee’s attorney, these fees are generally treated as taxable income to the employee or former employee. As a result, the employer must properly report the payments that are made. This means, for example, that an IRS Form 1099 that shows the attorneys’ fees paid may need to be filed with the government and may also need to be provided to the employee or former employee and his/her attorney.

The rules governing the reporting and withholding of income and employment taxes in the employer-employee context are complex and not necessarily intuitive. As a result, an employer who is resolving claims by an employee or former employee should consult with counsel to ensure that the employer is satisfying all of its obligations.

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