IRS’s New Position on Employer-Employee Relationships and the Definition of Wages

In Rev. Rul. 2004-110, the IRS effectively reversed its position on cancellation payments in the context of an employer-employee relationship. It concluded that amounts paid to an employee as consideration for the cancellation of an employment contract and relinquishment of contract rights were wages subject to FICA (Sec. 3121), FUTA (Sec. 3306) and Federal income tax withholding (Sec. 3402).

The ruling also broadened the Service’s historical view on the definition of wages and demonstrates a move toward a stricter construction of the exclusionary language contained in Sec. 3121(a), which defines wages for FICA purposes.

Overview

The IRS reasoned that the employment relationship encompasses the establishment, maintenance, furtherance, alteration or cancellation of the employer-employee relationship. For the payment not to be treated as wages, the employee would have to provide clear, separate and adequate consideration for the employer’s payment that is not dependent on the employee-employer relationship. The Service’s conclusion applies regardless of the name by which the remuneration is designated or whether the employment relationship still exists at the time of the payment.

In the ruling, the payment is taxable as ordinary income to the employee. It does not qualify as capital gain. A payment would have to be received in connection with a “sale or exchange” of “property” to be eligible for capital gain treatment under Secs. 1221, 1222 and 1231. Payment for the cancellation of an employment contract, the IRS concluded, is a substitute for ordinary income and not a payment for property.

The ruling did not address the employment tax treatment of liquidated damages paid by an employer to an employee as part of a settlement. Payments of such damages have been traditionally treated by the Service as nonwage payments. Certain payments representing liquidated damages made by an employer to its employees, the IRS concluded in Rev. Rul. 72-268, were not remuneration for employment and not wages for Federal employment tax purposes (including income tax withholding). However, these amounts were income to the employees and includible in their Federal income tax returns, according to the Service.

Ruling Reverses Previous Guidance

Rev. Rul. 2004-110’s conclusion is contrary to the IRS’s previously published guidance on cancellation payments in the context of the employer-employee relationship. The Service held in Rev. Ruls. 55-520 and 58-301 that cancellation payments were (1) not wages subject to FICA or Federal income tax withholding and (2) includible in the employees’ gross income in the year of receipt. Rev. Rul. 58-301 modified Rev. Rul 55-520 in noting that these payments were ordinary income, not capital gain. Rev. Rul. 58-301 was subsequently distinguished when the Service issued Rev. Ruls. 74-252 and 75-44, which held that employer payments were wages subject to FICA and Federal income tax withholding when they were made primarily for reasons other than contract relinquishment or cancellation.

Effective Date

The IRS will not apply this ruling to any employer payment to a former employee made before Jan. 12, 2005, if the payment is made under facts and circumstances substantially the same as in Rev. Rul. 55-520 or 58-301.

From Terence Coppinger, CPA, New York, NY, and Sharlene Sylvia, CPA, Washington, DC