Personnel Settlement Approval Process
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Sam Wilkins, Director
South Carolina Office
of Human Resources
8301 Parklane Road
Suite A220
Columbia, SC 29223
Phone: (803) 896-5300

INSPECTOR GENERAL'S
FRAUD HOTLINE

(State Agency fraud only)

1-855-SCFRAUD
or
1-855-723-7283

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 Adobe Acrobat of the State Human Resources Regulations.

  • Personnel Settlement Checklist


  • Proper Taxing of Judgments and Settlements


  • Tax Implications for Personnel Settlements


  • 2003 Memo from Sam Wilkins 



  • 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
    tax withholding.

    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:

  • Physical Injuries -- Includes all physical injuries sustained by the
    party. It may also include pain and suffering resulting from physical injuries.
    Payments of this nature are non-taxable.


  • Non-Physical Injuries -- Examples of non-physical injuries include
    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
    1099.


  • Emotional Distress and Mental Anguish -- Parties should first
    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.


  • Other -- Fees such as court costs, attorney's fees, and interest are
    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:

  • Identify the basis for the payment

  • Indicate the settlement amount

  • Allocate in writing each dollar of recovery to the respective category


  • If you have any questions regarding monetary settlements and possible tax
    implications, please contact your agency's Human Resources Consultant for
    additional information.