Employee settlements subject to employment tax.

• Author: Driscoll, David

Two of Y's 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 Y's treatment caused her to seek counseling and other medical assistance. Y and A's 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)...