Think You Have a Settlement? You May Have to Think Again
 
September 1, 2001
 

Ok – you have agreed with plaintiff’s counsel on the monetary settlement of an employment or labor law claim involving back wages. You also have hammered out a confidentiality provision and agreed on what Human Resources is going to say when a prospective employer calls for a reference concerning the plaintiff. So, you are done, right? Not so fast. If you have not figured how the settlement proceeds will be taxed, roll up your sleeves, and be prepared to get back into the trenches with plaintiff and his/her counsel.

Determining how settlement and severance payments relating to employment claims must be taxed has become increasingly difficult. Supreme Court decisions have required that, unless physical injury is involved, the entire payment is taxable as income. Further, the back pay and front pay portions of the settlement are taxable as wages, meaning that the employer must withhold all regular employee taxes – income taxes, FICA (Social Security), FUTA (federal unemployment) – from the settlement payment. Thus, an employer must issue a W-2 for the current tax year for both the plaintiff’s portion of the settlement, and, as some courts have found, for any portion of the settlement comprising attorneys’ fees as well.

The Supreme Court addressed another aspect of the taxation determination with its recent decision in United States v. Cleveland Indians Baseball Co. (April 17, 2001). In Cleveland Indians, the Supreme Court unanimously decided that FICA and FUTA taxes must be paid on the entire settlement amount in the year it is paid rather than allocating wages and taxes to the years the wages would have been paid if the employee had continued to work.

This issue arises when a settlement covers or potentially covers several years of earnings. For example, assume that an employee was terminated in 1996, sues under the ADEA, and settles the case in 2001, with no liquidated damages. Under the Cleveland Indians case, all of those settlement proceeds are taxable as income to the plaintiff in 2001. The Supreme Court rejected the employer’s claim that such settlement proceeds should be allocated to and taxed according to the years in which the employee would have received them, i.e., the portion of the settlement that constituted wages that should have been paid in 1996 should be attributed to 1996, and so on.

The Supreme Court’s decision has both good news and bad news for employers. The good news is that the Supreme Court’s rule is easy to apply. It is a lot easier to assess all payroll taxes for the year in which the settlement is paid, than to try to figure out what the employee would have been paid in previous years and make a series of retroactive changes.

The bad news for employers is the loss of flexibility and, in certain cases, more favorable tax treatment. This stems from the cap on income subject to FICA tax. Because FICA tax is assessed on only a portion of income, and the cap is increased each year ($80,400 maximum in wages taxed at 6.2% this year, for example), employers and employees may end up paying more tax under the new rule. For example, assume the employee from the example had earned $180,000 a year. Also assume that the settlement is $270,000, and is intended to compensate the plaintiff for lost wages for a year and one-half of work until he/she found another job making more money (the second half of 1996 and 1997). Thus, according to the Cleveland Indians decision, the entire $270,000 must be treated as year 2001 wage income and $80,400 is subject to FICA tax. However, if the alternative position had been adopted by the Supreme Court, the employer would have been able to exempt all $90,000 for 1996, because the employee had already earned more than the Social Security maximum for that year. In addition, only $65,400 of the settlement would be taxed in 1997 (representing the maximum wages taxed for FICA purposes in 1997). Saving the tax on that $15,000 ($80,400 - $65,400) may not seem like that big of a deal – but imagine a big class action for overtime, employment discrimination, or NLRA violations, and the benefit of the rejected position in Cleveland Indians becomes clear and substantial. In addition, employees subject to the additional FICA tax are likely to demand more to settle claims.

If you ever find yourself settling a claim involving back pay, consult counsel, and make sure you consider the tax implications – otherwise, you could easily make a mistake that could result in back assessments and IRS penalties.

For more information, contact Timothy M. Singhel at 1-888-688-8500 or via e-mail at tsinghel@hklaw.com.

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