Quirky Question #200, Reporting Payments Under Settlement Agreements
We try and settle threatened lawsuits with lump sum settlements which include wages, tort damages, reimbursement of medical costs and attorneys’ fees. We pay the lump sum to the employees’ attorneys (Trust fund), issue a 1099 to the employee for the amounts paid, not including attorney fees, and a 1099 to the attorney for the attorney fees. We require the ex-employee to indemnify us in the event taxes are not paid. Is that a best practice?
Answer: By Gabrielle Wirth
The indemnity is always a good idea, but reporting the amount correctly is even safer. On August 30, 2013, the IRS reissued advice on proper employment tax reporting on settlements in Chief Counsel Advice (CCA) Memorandum 20133501F. The CCA explained that payments made in settlement of wage based claims are generally considered wages that must be forwarded to the employee with a Form W-2. Most courts agree that settlement agreements to pay severance pay, back pay and front pay are payments of wages for employment tax purposes. Payments to compensate for a personal physical injury need not be on a W-2. Attorneys’ fees can be paid directly to the attorney but should be reported to the employee in Form 1099 Misc.
The IRS has been aggressively auditing settlement agreements with former employees and challenging any payments not reported on a W-2. While these general rules can help you structure a settlement, this is a fact specific and technical area of the law and you should always seek advice from your attorney or accountant.
In September of 2012, in Quality Stores v. United States 518 F3d 1328 (6th Cir. 2013), the Court of Appeals for the Sixth Circuit held that severance pay pursuant to an involuntary layoff was not subject to FICA taxes because it qualifies as Supplemental Unemployment benefits exempt under Section 3402 (o)(2). Some employees immediately filed protective claims for refunds of payroll taxes. The Federal Circuit had reached the opposition result in CSX Corp. v. United States 518 F3d 1328 (Fed. Cir. 2008).
Because of the split in authority, the IRS requested certiorari and the Supreme Court granted the request on October 1, 2013.
Employees who entered into severance agreements as part of an involuntary layoff should monitor this case and contact their attorneys and tax advisors to determine if a protective refund claim should be filed.
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