Allocating settlement proceeds in employment cases.

After the Small Business Job Protection Act of 1996 (SBJPA) significantly changed the taxability of settlement proceeds in personal injury cases, many practitioners thought that the opportunities to reduce the tax burden on settlement proceeds had been eliminated. However, careful examination of the settlement allocation may increase the after-tax proceeds available and employment disputes may allow reclassification and exclusion from employment tax.

Background

Under Sec. 104(a), settlement proceeds received on account of physical personal injury or sickness are excludible from income. Before the SBJPA, this exclusion also included emotional distress proceeds; thus, many wrongful termination, age discrimination and breach of contract cases included an emotional distress allocation. Because the Sec. 104(a) exclusion currently applies only to compensatory damages for actual physical personal injury or sickness, many settlement agreements for the types of cases noted above allocate the entire settlement proceeds to wages, subjecting it not only to ordinary income tax, but also to employment taxes (e.g., FICA, FUTA and state unemployment tax (SUTA)).

Settlement agreements may not mention the allocation of the settlement proceeds, but if they do, the tax adviser should scrutinize the wording. Generally, when the settlement agreement expressly allocates the settlement proceeds among various claims, the allocation is binding for tax purposes. However, to be respected, such allocation must be determined in good faith and at arm's length. For example, an amount paid to settle a lost-profits claim is currently deductible, but is ordinary income to the recipient. If the same amount is allocated as harm to a capital asset, it may be a capital gain to the recipient, but nondeductible by the payer. In some cases, the payer may be indifferent from a tax standpoint as to how the recipient allocates amounts in the settlement agreement (e.g., a tax-exempt entity). In such cases, the IRS and the courts are not bound by the allocations and may examine the claim's true nature and substance.

If the payer is engaged in a trade or business, any payments under a judgment or settlement in connection with such trade or business are deductible if Sec. 162 is met. However, Sec. 162(f) bars a deduction for fines or penalties paid to a government for the violation of any law. Under Sec. 162(g), the payer cannot deduct two thirds (i.e., the penalty portion) of treble damages paid to a plaintiff in an antitrust case.

When a controversy involves an employer-employee relationship, almost inevitably, the settlement proceeds will be ordinary income to the recipient. However, unless tax advisers properly allocate the proceeds, the proceeds will become subject to employment taxes as well. This classification will not only affect the recipient, it will also affect the payer, who would be responsible for the employer side of the employment taxes.

Sec. 3121(a) defines wages for FICA purposes as "all remuneration for employment." Employment is defined in Sec. 3121(b) as "any service, of whatever nature, performed ... by an employee for the person employing him.... "Case law indicates that wage income should be broadly construed. For example, in Social Security Board v. Nierotko, 327 US 358 (1946), the Supreme Court ruled that back pay the National Labor Relations Board ordered because an employee was wrongfully separated from his job, was wages for Social Security purposes. It noted that "service" means "not only work actually done but the entire employer-employee relationship for which compensation is paid to the employee by the employer."

To illustrate the magnitude of these taxes, a 7.65% rate (6.2% for Old Age, Survivors and Disability Insurance and 1.45% for Medicare) is due from both the employer and the employee on a wage base of up to $87,000 of income. They are subject to only the Medicare portion of 1.45% for wage levels in excess of that amount. However, if the employee works for more that one employer, each employer would have to withhold and pay FICA taxes on the wages paid. If the FICA withheld from an employee exceeds the maximum employee tax for the year, the employee would be entitled to a credit on his or her return for the year in question (this treatment would not be available to the employer).

In addition to FICA taxes, employers who have paid at least $1,500 of wages in a calendar quarter would also owe FUTA. The tax is based on the first $7,000 of wages paid to an employee during the calendar year. The full tax rate is 6.2%, but the employer is allowed a partial credit against this tax based on its state unemployment insurance tax liability or its SUTA tax. The maximum per-employee amount for FUTA and SUTA is $434.

Is It Wages?

Settlement proceeds can be allocated to a number of categories without creating wages to the recipient, yet creating deductible amounts to the payer. The IRS, in published guidance, has outlined a number of cases in which amounts paid to employees are not wages. For example, in Rev. Rul. 58-145, the issue was the wage treatment of signing bonuses paid to baseball players. The Service concluded that bonuses paid to new players solely for signing their contracts, without any requirement of subsequent service, were not remuneration for services performed and, thus, not wages.

However, it subsequently issued Rev. Rul. 69-424 and ruled that amounts paid to a college by a baseball club on behalf of a baseball player under contract to play baseball for a minor league team were wages for FICA and FUTA purposes. In Rev. Rul. 71-532, it noted that the signing bonus in Rev. Rul. 58-145 was excepted from the wage category, because such payment did not require future services.

In Rev. Ruls. 55-520 and 58-301, the IRS ruled that amounts received on cancellation or relinquishment of an employment contract were ordinary income to the recipient, but not wages for FICA or income tax withholding. In each ruling, the original employment contract specified that it was fork fixed term and pay rate. Nonetheless, the Service appears uncomfortable with this published guidance and routinely resists characterizing amounts paid by an employer in accordance with it as nonwage income.

For instance, in Rev. Rul. 74-252, it narrowed the previous rulings' reach; a contract that provided for payments equal to six months' salary if the employer terminated the contract before the end of its three-year term constituted wages. The Service determined that the payments were dismissal payments made under the contract's terms, not payments for canceling or relinquishing the contract. The only difference between Rev. Rul. 74-252 and the earlier rulings was that the amount to be received on cancellation was negotiated ahead of time.

In Rev. Rul. 80-364, the IRS ruled that interest is not wages. In situation 1, an individual sued his former employer for back pay. The court awarded an amount as back pay and an amount as interest. The Service concluded that the "payments for interest ... are not wages, because they are not remuneration for employment." This ruling has been consistently followed by the IRS in the settlement context.

Also addressed in this ruling was the nonwage character of attorney's fees. The Service concluded that these fees, specifically court-ordered, were not remuneration for employment and, thus, not wages. In situation 2, the court ordered damages without specifying any amount for interest or attorney's fees, treating the entire recovery on the back-pay claim as wages. The conclusion was that "the full amount of the award is income to the employee and it is also wages for federal employment tax purposes, notwithstanding that a portion of it was spent on attorney's fees."

In Rev. Rul. 72-268, the IRS treated liquidated damages paid in connection with wage claims under the Fair Labor Standards Act of 1938 and the Walsh-Healy Government Contracts Act as other than wages, because they penalized a failure to comply with the law. It reached the same conclusion as to a closing agreement on the tax treatment of payments settling an antitrust suit involving claims by a class of NCAA coaches. The result was that one-third of the settlement constituted wages; two-thirds constituted ordinary income, not wages.

As discussed above, Congress amended Sec. 104(a)(2) in the SBJPA to remove the exclusion from income of settlement payments for emotional distress. Still unsettled is whether post-SBJPA settlements for emotional distress are wages for employment tax purposes. While the IRS had the opportunity to rule on this issue in Rev. Rul. 96-65, it stopped short of providing a definitive answer. It concluded that compensation received for emotional distress experienced due to a denial of a promotion was income; further, back pay was wages includible in gross income for employment tax purposes. The Service did not reveal whether the emotional distress damages were back pay. Based on the earlier rulings, which concluded that other categories are not remuneration for employment and are not subject to employment taxes, tax advisers could draw the conclusion that a payment for emotional distress is not remuneration for services.

Conclusion

When involved in a situation concerning settlement proceeds, tax advisers should pay particular attention to the nature of the claim and the tax treatment to both the payer and recipient. There are many opportunities to analyze whether settlement proceeds should be considered wages subject to employment taxes or some other type of claim exempted from the usage category.

FROM TRACY J. MONROE, CPA, MT, COHEN & COMPANY, LTD., CLEVELAND, OH