|Personnel Settlement Approval Process|
It is the policy of the State Budget and Control Board that settlement proposals be presented to the Board for approval. See Section 19-718.11 of the State Human Resources Regulations.
Proper Taxing of Judgments and Settlements
Imagine that a state employee brings an action against the employing agency for an alleged wrongdoing. Once the employee takes the necessary steps and the legal engine begins turning, four possible outcomes can result: the action is dropped, the employee loses in the action against the employer, the employer settles with the employee, or the employer loses and must statisfy a judgment entered in favor of the employee. If the employer wins or the employee drops the action, the employer does not have to be concerned with any tax consequences because no money changed hands from the employer to the employee. If the employer settles with the employee or loses an adjudication whereby the employer must satisfy a monetary judgment, employers must be aware of the tax requirements involved with that settlement or judgment.
The first thing employers must know is that settlements and judgments are
treated exactly the same when it comes to the tax consequences. Longino v.
Comm, 32 TC 904 (1959). There are at least three categories of damages the
employee may recover: physical injuries, nonphysical injuries, and back wages.
Recovery of damages for physical injuries is not taxable income. Nonphysical
injuries (which include interest, court costs, and attorney's fees) are subject
to income tax. IRC Section 104. Recovery of back pay is subject to the same taxes as
if it had not been held back. See U.S. Gilmore 372 US 39 (1963). Therefore,
when back wages are paid as a result of a settlement or judgment, payments are
subject to FICA, FUTA, state unemployment tax, state income tax, and federal
Since the nature of recovery directly affects the taxing of settlement and
judgment payments, employers must specifically allocate each dollar of recovery
to its respective category of damages in either its settlement agreement or
court order. Failure to allocate damages into categories will allow the IRS, in
its discretion, to allocate damages or to treat the entire payment as back
wages, Rev. Rul. 80-364. This reallocation or treatment by the IRS may result
in additional employer liability, employee's portion of FICA for the increased
amount, plus penalties and interest, as well as employer liability for failure
to withhold taxes, plus penalties and interest.
Employers should use either of two methods to help determine allocation of
damages. First, how the employee's complaint allocates damages ultimately
drives these methods of allocation. For example, a complaint claims a total
dollar amount of $100,000 in damages. To reach that amount, the complaint
claims $50,000 for back wages, $30,000 for physical injuries, and $20,000 for
attorney's fees. Therefore, 50% of the total amount goes to back wages, 30%
goes to physical injuries, and 20% goes to attorney's fees. This same
percentage of allocation should be applied to the amount ultimately recovered
by the employee whether through settlement or judgment. Second, if the
employee's complaint does not contain these specific allocations, the employer
should determine a reasonable allocation based on the facts and circumstances
surrounding the case. Employers should maintain a file containing any
documentation that supports the allocation they have made. Again here, the IRS
may reallocate in the settlement or judgment to be unreasonable. A reallocation
by the IRS may result in additional employer liability.
According to Rad Burch of Haynsworth, Baldwin, Johnson, and Greaves, once a
reasonable allocation has been made, the settlement agreement or court order
should include a provision that the employer will make all tax withholdings and
file all tax forms as required by applicable state and federal tax law. The
employer should report the back wages portion of the settlement on Form W-2.
The employer should report all other taxable portions of the settlement on Form
1099, even the payments made to the plaintiff's attorney. Alexander v. IRS, 77
AFTR2d96-301 (1st Cir. 1995); IRC Section 6041; and instructions to Form 1099. In
addition, under a new tax law, which became effective on January 1, 1998, the
employer must send a Form 1099 for any payments made to attorneys or law firms. IRC Section 6045(f).
Agencies should keep these tax considerations in mind both during preparation
of a settlement agreement or court order and during the administration of the
outcome. Handling settlements and judgments in the appropriate manner will help
agencies limit their liabilities to those arising out of their relationships
with their employees and eliminate the possibility of further liability at the
hands of the IRS.
Tax Implications for Personnel Settlements
The Spring 1999 issue of the HR Review contained an article entitled "Proper
Taxing of Judgments and Settlements." This article raised the awareness to
agencies of tax considerations regarding lump sum payments contained in
personnel settlements. Questions often arise when parties are attempting to
negotiate monetary payments in settlement of employment disputes. This article
will attempt to simplify how lump sum payments are subject to taxes and
withholdings. Parties to a monetary settlement must first determine the reasons
for the payment. This determination will assist in deciding whether the payment
is wage-based or non-wage based.
If wage-based The payment is subject to the standard state and
federal withholdings. For example, FICA, FUTA, state unemployment tax, state
income tax, and federal tax withholdings will be deducted. The employer is
responsible for reporting the wage-based payment on a W-2 Form. Examples of
wage-based payments may include: back wages, future wages, allegations of
inequity in pay, and misclassification of position.
If non-wage based These types of payments fall into several
categories. Parties will need to determine which categories are appropriate
based on the origin of the claim. These categories include:
party. It may also include pain and suffering resulting from physical injuries.
Payments of this nature are non-taxable.
defamation, conspiracy, and free speech violations. Payments of this kind are
subject to income tax and should be reported by the employer on a Form
consider whether the emotional distress is caused by a physical or non-physical
injury. If the emotional distress is caused by a physical injury the payment is
considered non-taxable. If, however, the emotional distress is caused by a
non-physical injury, the payment will be taxable income. This income should be
reported by the employer on a Form 1099.
subject to tax and should also be reported on a Form 1099.
Again, the responsibility for determining whether the lump sum payment is
wage-based or non-wage based rests with the parties involved in settling the
dispute. To ensure that your settlement is allocated properly, parties should:
If you have any questions regarding monetary settlements and possible tax
implications, please contact your agency's Human Resources Consultant for