IRS's new position on employer-employee relationships and the definition of wages.

• Author: Coppinger, Terence

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 non-wage payments. Certain payments...