IRS Reaffirms Advice On The Proper Employment Tax Treatment Of Settlements

On August 30, 2013, the IRS reiterated its longstanding positions on the proper tax treatment of litigation settlements with current or former employees. In its Chief Counsel Advice (CCA) Memorandum 20133501F, the IRS presented and answered three questions:

When are attorney's fees paid by an employer as part of a settlement agreement with a former employee subject to employment taxes? What are the information reporting requirements for attorney's fees paid by an employer pursuant to a settlement agreement with a former employee? What penalties can be asserted if an employer fails to comply with reporting requirements for attorney's fees paid as part of a settlement agreement with a former employee? Background Facts

An employer enters into several typical settlement agreements with former employees wherein the employees waive rights to bring further claims under various statutes such as the Age Discrimination in Employment Act (ADEA), the Americans with Disabilities Act (ADA), and Title VII of the Civil Rights Act (Title VII) in exchange for lump sum payments. The lump sum payments are characterized as including wages, tort damages, reimbursements of medical costs, and attorney's fees. The attorney's fees are, variously, paid directly to the employee, only to the employee's attorney, or jointly to the attorney and the employee.

The Memorandum addresses three examples of settlement payments that include attorney's fees. In the first example, all sums but attorney's fees are reported on a 1099 issued to both the employee and counsel. In the second example, the employer reports the lump sum payment as wages on a W-2 to the employee and attorney's fees on a 1099 to counsel, but does not report any portion of the attorney's fees on a 1099 to the employee. The third example includes a lump sum to settle all claims paid to the employee's attorney without any allocation between types of claims or claims and attorney's fees.

Analysis

The IRS began its analysis by laying out a four-step process:

First, determine the character of the payment and the nature of the claim that gave rise to the payment. Second, determine whether the payment constitutes an item of gross income. Third, determine whether the payment is wages for employment tax purposes. Fourth, determine the appropriate information reporting for the payment, including payments of attorney's fees. The CCA does not analyze the first step in the process, explaining that this determination...