Recent Case Serves as Reminder That Settlement of Employment Claims Triggers Employer Reporting and Withholding Obligations

Nov. 7, 2013

On Oct. 28, 2013, the Tax Court in Simpson v. Commissioner of Internal Revenue held that the tax characterization of a settlement payment in an employment-related dispute is determined by the nature of the settlement proceeds, making the ultimate inquiry one of intent. In other words, the court’s ruling focuses on what the settlement payment is intended to compensate.

In Simpson, the parties intended that the settlement proceeds be workers’ compensation proceeds. Under the Internal Revenue Code, amounts received under workers’ compensation are not taxable. However, the settlement in Simpson did not comply with the specific state law requirements for workers’ compensation settlements. As a result, the exemption was not available and the settlement proceeds were taxable to Simpson.

While the Simpson case focused on the tax characterization of settlement proceeds and the resulting tax consequences to the employee, the tax characterization of a settlement payment is equally important to the employer. From an employer’s perspective, a settlement payment that constitutes taxable income to the employee triggers tax reporting and withholding obligations for the employer.

  • Any portion of the settlement proceeds attributable to wages (salary, back pay, front pay, overtime pay, severance pay, benefits) must be reported to the employee on Form W-2, “Wage and Tax Statement.”
  • An employer is required to withhold income and employment taxes on any portion of a settlement payment attributable to wages.
  • All nonwage taxable payments – such as attorney’s fees, interest, compensatory damages paid on account of physical injuries or physical sickness, and punitive damages – are reportable to the employee on a Form 1099, “Miscellaneous Income.”
  • In addition to its tax reporting obligations with respect to the employee, the employer also might have a 1099 reporting obligation with respect to the employee’s attorney if any portion of the settlement payment is intended as compensation for attorney’s fees.

It is important that employers understand the nature and character of employment-related settlement payments in order to properly report and withhold tax.

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David Holets
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Howard Wagner
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