Tax treatment of employment-related judgments and settlements.

• Author: Mirpuri, Shashi

Recent program manager technical assistance from the Office of Chief Counsel (PMTA-2009-035) provides a detailed analysis of the IRS's position on dealing with income and employment tax consequences, as well as appropriate reporting, of employment-related judgment or settlement payments. The PMTA goes on to state that determining the correct treatment of employment-related settlement payments is a four-step process:

* Determine the character of the payment and the nature of the claim that gave rise to the payment;

* Determine whether the payment constitutes an item of gross income;

* Determine whether the payment is wages for employment tax purposes; and

* Determine the appropriate reporting for the payment and any attorneys' fees (Form 1099 or Form W-2).

This item highlights the PMTA's key areas and points out important concepts.

Character of the Payment and Nature of the Claim

There are numerous types of settlement payments or awards that an individual may receive in connection with an employment-related dispute. Some of these payment types include severance pay, back pay, front pay, compensatory damages, consequential damages, and punitive damages. In addition, depending on the specific set of facts and circumstances, the nature of the claim can be tied back into a federal provision or statute. Some of the most widely known of these include title VII of the Civil Rights Act of 1964, the Back Pay Act, the Age Discrimination in Employment Act of 1967, and the Fair Labor Standards Act of 1938.

Taxable or Not

The first step in deciding whether a payment or settlement is taxable can be found in Sec. 104. Sec. 104(a)(2) states that "gross income does not include the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness." While this definition might seem clear and concise, there are several things to point out.

First, in order to comply with the regulations promulgated under Sec. 104, payments of damages must have been received either through prosecution of a legal suit or in a settlement agreement in lieu of prosecution of a suit. A general release of claims against an employer under a termination plan or severance package is not a claim under Sec. 104 and thus is taxable. Second, emotional distress cannot be treated as a physical injury or physical sickness, so payments in connection with an...