Employee Settlements Subject to Employment Tax  

Two of Ys former employees, A and B, filed employment discrimination complaints against Y. They both signed settlement agreements in which they agreed to release all claims against Y in exchange for a sum of money. The parties have not asserted that any portion of the settlement payments is excludible from gross income under Sec. 104(a)(2). The issue presented is the portion of the payments that constitute wages subject to employment taxes.

A filed charges of discrimination with the Equal Employment Opportunity Commission (EEOC) under Title VII of the Civil Rights Act of 1964 and the Americans with Disabilities Act (ADA). Additionally, she alleged violations of the Family and Medical Leave Act and breach of contract. A claimed injury and damages, including mental and emotional anguish and distress and asserted that Ys treatment caused her to seek counseling and other medical assistance. Y and As settlement agreement allocated one half of the total payment to damages for lost wages; Y reported this amount as wages on Form W-2. The remainder was allocated to damages for personal injury and emotional distress; Y reported this amount on Form 1099.

B filed charges of employment discrimination with the State Department of Human Rights and the EEOC, alleging age discrimination under the State Human Rights Act (SHRA) and the Age Discrimination in Employment Act of 1967 (ADEA). Specifically, B claimed that Y had terminated his employment for unlawful reasons relating to age. The settlement agreement allocated one third of the total payment to back pay, and the remainder to damages for emotional distress.

Analysis

Settlement payments may be wages subject to FICA, FUTA and income tax withholding. For income tax withholding purposes, Sec. 3401(a) broadly defines wages as all remuneration for services performed by an employee for his employer, with specific exceptions. Under Secs. 3121(b) and 3306(c), employment for FICA and FUTA purposes means any service, of whatever nature, performed by an employee for the person employing him, again with specific exceptions.

Whether an amount received in settlement of a dispute is remuneration for employment and subject to employment tax depends on the nature of the item for which the settlement amount is a substitute; see Alexander, 72 F3d 938 (1st Cir. 1995).

The IRS is not necessarily bound by allocations contained in settlement agreements to which it was not a party; see Robinson, 102 TC 116 (1994), revd in part on other grounds, 70 F3d 34 (5th Cir. 1995), cert. den. An allocation can be challenged when the facts and circumstances indicate that it does not reflect the settlements economic substance. In addition, the Tax Court has held that the settlement allocation is generally binding for tax purposes to the extent it is entered into by the parties in an adversarial context, at arms length and in good faith (Robinson). Additionally, a proper characterization (i.e., tort or nontort) of a settlement payment will depend in part on the types of remedies available for the claim asserted against an employer.

A asserted her claim under Title VII and the ADA. Title VII allows for the recovery of back pay, compensatory and punitive damages and attorneys fees. The ADA employs the same remedial scheme as Title VII, as amended in 1991; see 42 USC Section 12213. As underlying claim (i.e., that Y discriminated against her) is a wage-based claim. However, A also claimed damages for emotional distress, a tort-based claim. A review of the information provided indicates that A exhibited symptoms of emotional distress and sought medical and psychiatric treatment as a result of Ys alleged discrimination. Moreover, there is no question that Y was apprised of these symptoms and treatment at the time the settlement was executed. Thus, Y intended to compensate A for these personal injuries; the allocation accurately reflects the realities of As underlying claims.

Accordingly, the allocation in As settlement agreement is reasonable. Because the payments allocated to emotional distress do not constitute remuneration for services, they are not wages subject to employment taxes.

B asserted his claim under the SHRA and the ADEA; the latter allows for the recovery of back pay, front pay, liquidated damages and attorneys fees. The SHRA allows for the recovery of compensatory damages and attorneys fees, including damages for emotional distress.

The underlying documents establish that, in his complaint, B requested damages for economic injuries and did not seek damages for emotional distress or other personal injury. In fact, the only reference to emotional distress is a single statement in the settlement agreement signed by B: I further allege that I suffered emotional distress as the result of this termination. This information contains no indication that B suffered any symptoms of emotional distress or sought treatment.

Under these circumstances, there is no factual basis for allocating two thirds of the total amount paid to B to emotional distress; the allocation does not reflect the economic substance of the settlement, nor the realities of the underlying claim. Moreover, the parties were not adversarial as to the allocation, as both would benefit from characterizing the bulk of the settlement to emotional distress (thereby avoiding liability for employment taxes). Accordingly, the proper characterization of the entire settlement made to B is wages subject to employment taxes.

IRS Letter Ruling (TAM) 200244004 (11/1/02)