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Is it wages?


* In certain cases, termination payments and settlement damages paid to an employee are not considered wages.

* An employer's withholding obligation may be reduced based on either a reasonable expectation that no obligation existed or a lack of adequate notice of the duty to withhold.

* In many cases, plan documents can provide alternative definitions of compensation for retirement benefit purposes.


Although wages are broadly defined not all payments by employers to employees are wages subject to income tax withholding and payment of employment taxes. In fact, relief from the duty to withhold or the obligation to pay employment taxes can substantially reduce an employer's liability. This article examines recent cases defining wages and their corresponding effect on withholding and employment tax obligations and on retirement benefits.

Defining the Issue

In the absence of regulatory exclusion, wages are treated similarly for purposes of income tax withholding and employment tax obligations. (1) For employment tax purposes, Secs. 3121(a) and 3306(b) broadly define wages as "all remuneration for employment" The definition provided in Sec. 3401(a) is essentially identical for income tax withholding purposes. The question is which payments fall outside the definition of wages from the start. (2) For instance, past service and current wages may be a factor in valuing either tort and tortlike compensatory damages or contract and property rights, yet these payments ate not wages. If payments are not wages, the employer incurs neither a primary nor a secondary obligation to withhold or pay employment taxes.

If payments are wages, three additional questions arise:

* Does the obligation to withhold exist? As a secondary obligation, an employer's duty to withhold will not arise if it either reasonably expects the employee to incur business expenses or lacks adequate notice of its duty. When an employer has no obligation to withhold, the government must collect the employee's portion of the tax directly from the employee.

* When are employment taxes calculated? Is the tax rate based on the year in which the wages should have been paid or in the year actually paid? According to the Supreme Court, (3) the year the wages are paid controls.

* Will the employer incur a liability to increase retirement benefits? When definitions of compensation for purposes of retirement benefits are either ambiguous or follow one of the safe-harbor definitions provided by Regs. Sec. 1.415-2(d)(11)(i), a designation as wages for employment tax purposes may trigger a corresponding employer liability to increase an employee's retirement plan benefits.

Is It Wages?

Although wages and employment are read broadly in the FICA context, not all payments by employers to employees are clearly wages. The payments must be remuneration for services provided by the employee to his or her employer to be subject to FICA taxes. (4)

What remuneration for services is actually called and on what basis it is paid is immaterial. (5) Further, the employment relationship need not exist at the time the remuneration is paid. (6) Although wages are remuneration for employment, employment has been broadly defined to mean not only work actually done, but "the entire employer-employee relationship for which compensation is paid to the employee by the employer." (7) Yet, not all payments from employers are wages. Recognizing when payments may not be wages is the first step toward reducing withholding and employment tax liability.

Dismissal Payments

Under Regs. Sec. 31.3401(a)1(a)-1 (b)(4) and Rev. Rul. 74-252, (8) wages generally include payments made by an employer to an employee who is involuntarily dismissed, whether or not the employer is legally bound to make the payments. But even dismissal payments (voluntary or involuntary) will not be wages if they rail to represent remuneration for employment. Typically, four types of employee termination payments are made by employers; two are wages and two are not:

1. Contractual termination clause: Payments required by an employment contract termination clause usually represent anticipated earnings and are wages.

2. Rights earned by past service: A lump-sum payment made for the relinquishment of seniority rights that had been awarded based on an employee's prior service are wages.

3. Relinquishment of contract rights: Payments to obtain the release of a noncompensatory contract right are not wages.

4. Supplemental unemployment compensation: Under Sec. 3402(o), payments for involuntary termination of employment as a direct result of a reduction in workforce are not wages.

The amount of employee termination payments is calculated by considering past performance and current salary. Although this calculation is indicative of wages, the method of calculation will not be controlling if the payment is for a noncompensatory contract right protected by law and has an exchangeable value. (9) Key elements in establishing the existence of a noncompensatory contract right for which payments are made include: (1) the existence of an employment contract for either a fixed term or life (e.g., tenure) rather than at-will and (2) the separate negotiation for relinquishment of interests the employee had in his or her employment contract in the nature of property, rather than payment for termination under provisions of the existing employment contract. (10)

In North Dakota State University, (11) the Eighth Circuit distinguished payments to tenured employees from similar payments to at-will employees, finding that the former payments were for contract rights (in the nature of property) that did not represent wages. Unlike seniority rights awarded for past service, granting tenure created rights protected by law that extended beyond those of at-will employment. There was exchangeable value, because the contract right had value to the individual faculty member who held it, even though that right could not be transferred to another. The IRS later issued a nonacquiescence in this case; the Court of Federal Claims, in CSX Corp., Inc., (12) refused to follow North Dakota State University:

This court can see no basis upon which to distinguish between the tenure rights considered in North Dakota and the contract rights at issue here. In each case, the surrender of these rights in return for a cash payment represents the surrender of enforceable rights to future earnings in return for a present sum.

In CSX Corp., Inc., however, the Court of Federal Claims did find that employer payments to an employee involuntarily separated as part of a reduction in workforce were supplemental unemployment compensation and not wages. It based its decision on the definition of wages and the limits placed on that definition by Sec. 3402(o).

Allocation of Damages

A settlement often involves more than a single claim for damages. For example, damages may be sought for age discrimination, invasion of privacy, defamation, intentional infliction of emotional distress and wrongful termination of employment. Some claims may be based on theories of either tort of contract. Ira settlement compensates for tort or tortlike claims, the payment will not be wages. By compensating for personal injuries rather than employment, neither the obligation to withhold nor the obligation to pay employment taxes arises.

When allocating a settlement to a tort of tortlike claim, the claim must be bona fide (i.e., nonfrivolous), but not necessarily valid or sustainable. (13) The allocation could be relied on for tax purposes if entered into in good faith between adversarial parties. (14) The Tax Court has disregarded allocations in settlement agreements when:

* One of the parties did not care how allocations were made (making the parties nonadversarial as to that issue);

* Allocations were entirely tax motivated; and

* Pleadings and record of litigation were unsupportive of the allocation. (15)

Allocating a settlement to tort or tortlike claims may, in certain circumstances, exclude the settlement from the recipient's taxable income. Sec. 104 limits the income tax exclusion for damages received after Aug. 20, 1996 (unless received pursuant to suits filed prior to that date) to compensatory damages for physical injury, physical sickness or wrongful death. The Small Business Job Protection Act of 1996 Committee Report notes that if "an action has its origin in a physical injury or physical sickness, then all damages (other than punitive damages) that flow therefrom are treated as payments received on account of physical injury ..." (16) For instance, compensation for emotional distress that results from a physical injury or sickness would be excluded from income, but such compensation flowing from a claim of employment discrimination or injury to reputation that did not involve a physical injury would be included in income. Although, in the latter case, compensatory damages are included in income, the damages allocated for these tort or tortlike claims are not subject to withholding and employment tax obligations. Conversely, damages allocated to nontortious claims may represent wages; if so, they will incur these additional tax obligations.

If a settlement fails to allocate damages (or is disregarded), the most important factor will be the payor's motivation. For example, in Reisman, (17) unallocated settlement amounts were wages, even though suits claimed tort and tortlike injury, because the "overarching desire" of the employer-payor was to remove the plaintiff as an employee. Thus, it is critical to allocate settlements to tort of tortlike claims supported by the record.

Claims Release in a Termination Agreement

In a typical termination agreement, the employee releases the employer from "all claims, demands, actions or liabilities, including but not limited to those which are related to ... employment" or its termination. Released claims may include discrimination (whether based on theories of tort or contract), but the mere release of all claims in the agreement will not allow a portion of the payments to be attributed to tort settlement and excluded from wages. (18)

Whether the termination is voluntary of involuntary, severance pay will be wages if it is (1) based on a standard formula and (2) employees fail to raise issues of personal injury and negotiate a payout that differs from the standard formula. Exit-incentive payments are "wages," because "remuneration for employment" as defined for employment tax purposes includes compensation not only for work actually performed, but also the entire employer-employee relationship for which compensation is paid to the employee.

Attorney's Fees

A separate award of attorney's fees will reduce the wages subject to withholding and employment taxes, but not the recipient's taxable income. If, however, the employee is awarded severance pay from which he or she then pays attorney's lees, the entire award will be wages subject to withholding and employment taxes.

For example, Rev. Rul. 80-364 (19) presented three situations in which amounts paid by an employer to an employee were partially used for attorney's fees. In the first, the court awarded back pay and separate attorney's fees. The IRS ruled that only the portion of the award specified for back pay was wages. In the second situation, the court awarded back pay but did not allocate an amount to attorney's fees of to interest. The entire amount was wages, including the amount the employee subsequently paid for attorney's lees. In the last situation, the company paid a labor union a settlement for all claims filed by the union on behalf of its members. The union used a portion of the settlement to pay attorney's fees. The IRS ruled that the amount paid for attorney's lees was not wages, as it was not remuneration to the individual employees; rather, it was reimbursement of expenses incurred by the union.

Reimbursed Employee Business Expenses

Reimbursements paid to an employee under an accountable plan are exempt from withholding and employment taxes under Regs. Sec. 1.62-2(c)(4). For nonaccountable plans, Regs. Sec. 1.62-2(c)(5) states that reimbursements (or advances) that are "included in the employee's gross income, must be reported as wages or other compensation on the employee's Form W-2, and are subject to withholding and payment of employment taxes."

While Regs. Sec. 1.62-2(c)(2)(i) establishes a three-prong test for determining whether an accountable plan exists, the Eleventh Circuit, in TRUCKS Inc., (20) noted that the question of reasonable belief underlies these three prongs. Similarly, fringe benefits will be excluded from the definition of wages under Secs. 3121(a)(20), 3306(b)(16) and 3401(a)(19) for purposes of the obligation to withhold or pay employment taxes, if the employer has a "reasonable belief" that the employee will be able to exclude the fringe benefit from income.

Reasonable belief is determined under an objective standard. The employer must have gathered sufficient evidence to support its belief. For the purpose of determining an employer's primary liability to pay employment taxes, the focus of this evidence should be on the deductibility of an expense by a specific employee. A reasonable basis will not exist when, as in American Airlines, (21) the employer either assumes employees will retain records to enable them to seek reimbursement for travel expenses in excess of the per diem provided, or it relies on the occasional receipt of detailed travel records produced during union labor negotiations from an unspecified number of employees.

Determining the Amount of Employment Taxes

In Cleveland Indians Baseball Club, (22) the Supreme Court determined that back pay is subject to withholding and employment taxes in the tax year in which it is paid, rather than in the tax years to which it related. The issue of when the obligation is incurred is significant, because (1) the tax rate and base have increased over time and (2) an employer receives no reduction in employment taxes for an employee with multiple employers.

Under Sec. 6413(c)(1), an employee with multiple employers is entitled to a credit or refund of any excess FICA tax paid; the multiple employers receive no refund. When a back wage is awarded, the employee would be more likely to have multiple employers if the employment tax liability arises in the year the back wage is paid.

Obligation to Withhold

Relief from the employer's secondary obligation to withhold taxes on wages may occur even though an employer remains liable under its primary obligation to pay employment taxes. An employer's withholding obligation may be reduced based on a reasonable expectation that no obligation to withhold existed or on the employer's lack of adequate notice of his or her duty to withhold. In determining whether a duty to withhold exists, the focus is on whether the expense was ordinary and necessary to the employer's business, rather than whether it was deductible by the employee.

Reasonable Expectation

In providing an exception from the requirement to withhold employment taxes, Regs. Secs. 31.3401(a)-1(b)(2) and 31.3121(a)-l(h) state that advances or reimbursements paid for traveling of other bona fide ordinary and necessary expenses incurred or reasonably expected to be incurred in the employer's business ate not subject to withholding.

The "reasonable expectation" must be based on objective information, but need not relate to a specific employee; for withholding purposes, the test focuses on the employer's business. (23) For instance, the Federal Circuit, in American Airlines, remanded the case to the Court of Federal Claims to consider the following independent objective information:

* Travel cost studies prepared by a well-known international consulting firm specializing in such costs.

* The experiences of the employer's own management.

* Per-diem amounts paid by other competitors.

* The government's own per-diem rates.

An employer relieved of its income tax withholding based on a reasonable expectation remains liable for its primary obligation of employment taxes, as does the employee. However, the elimination of this duty to withhold will substantially reduce the employer's liability.

Adequate Notice of Duty to Withhold

An employer's secondary obligation to withhold employment taxes is not imposed unless the employer has "precise and not speculative" notice of its duty. While this concept was first applied in Central Illinois Public Service Co., (24) several recent cases have examined whether notice to withhold was adequate.

In HB&R, Inc., (25) an employer lacked precise notice when regulations were not clear and the government had never before asserted that income and FICA tax withholding applied to the reimbursement of employee travel expenses incurred to transport employees from their residences to remote sites where they worked. But, in both North Dakota State University and American Airlines, the employer was found liable under its secondary obligation to withhold. In the first instance, the employer failed to provide all the facts when asking the Social Security Administration to clarify its obligation. In the latter case, the court found that the employer had adequate notice of its duty to withhold given the income tax statutes and regulations in effect at the time the employer provided working-condition fringe benefits.

Use of this defense requires a documented review of all relevant tax statutes and regulations in effect at the time the payments are made and, if a government opinion is sought, a complete disclosure of all the facts.

Retirement Benefits

If a qualified defined benefit or defined contribution plan defines compensation using the sale harbors found in Regs. Sec. 1.415-2(d)(11)(i), compensation will equal the wages used for employment tax purposes. Severance pay classified as wages for employment tax purposes, will require a corresponding increase in funding for retirement plan benefits. Planning may change this result.

Benefit Accrual

Regs. Sec. 1.415-2(d)(2)(i) requires that amounts counted as compensation for retirement benefits be for "personal services actually rendered in the course of employment." It does not require that the services be provided in the same year that compensation is paid. Unless the plan otherwise defines compensation, this requirement permits back pay or severance pay to be counted as compensation for the purpose of computing benefits, even though the actual service was provided in an earlier year. If this is not the desired result, the plan documents should provide an alternative definition of compensation.

Plan documents may use an alternative definition of compensation that is nondiscriminatory when compared to the safe-harbor definitions. Under Regs. Sec. 1.414(s)-1(d)(2)(ii), a nondiscriminatory alternative definition may exclude irregular or additional compensation (such as overtime pay, premiums for shift differential and bonuses). Severance pay is similar to these examples, permitting an alternative definition to exclude it; however, back pay would not appear to fit within this exclusion.

If the plan definition of compensation for purposes of calculating pension benefits is not clear in its treatment of severance pay, the courts look to its past treatment. For instance, a retirement plan summary that defined compensation for purposes of the pension plan as "gross earnings paid except for prizes, awards and ... foreign allowances" was found to be an ambiguous definition. Although a severance plan recipient argued for the inclusion of severance pay in the calculation of benefits because it was not specifically excluded by this definition, the Seventh Circuit, in Krawczyk v. Harnischfeger Corp., (26) denied its inclusion, stating that to do so would provide a "pension windfall" and would be inconsistent with the employer's previous treatment of severance pay.

Individual severance agreements should address whether severance payments are to be included as compensation for purposes of calculating pension benefits. In Licciardi v. Kropp Forge Div. Employees Retirement Plan. (27) severance payments that the agreement indicated were additional compensation for past services were excluded from the calculation of pension benefits by the court, because the agreement released the company from "contestable plan issues."

To reduce the possibility of additional retirement plan benefits, qualified plans should define compensation to specifically exclude severance pay; termination agreements should include a release of qualified plan issues.

Elective Deferrals

Elective deferrals under a Sec. 401(k) plan should also be considered. For this purpose, timing of the severance pay is a factor, as elective deferrals may only be made by "eligible employees." Regs. Sec. 1.401(k)-1(a)(2), (g)(4) and (5) do not include former employees as eligible employees. This suggests that a lump-sum severance package made before the last day would be eligible for deferral, but that one made after termination would not be eligible.

Elective deferrals for cafeteria plan purposes appear to be less restrictive than for Sec. 401(k) plans. Severance pay, regardless of its timing, should be eligible for an elective deferral, because Prop. Regs. Sec. 1.125-1, Q&A-4, authorizes active participation in a cafeteria plan by former employees.


Not all payments from employers to employees ate wages. If payments are not wages, the employer's obligations to withhold, pay employment taxes and accrue retirement benefits are reduced. Given these potential liabilities, planning should include a determination of whether payments are wages.

For more information about this article, contract Professor Stara at

(1) CSX Corp., Inc., 52 Fed. Cl. 208 (2002); see Jones, Tax Clinic, "Potential Refund of Payroll Taxes on Severance Pay," 34 The Tax Adviser 80 (February 2003).

(2) CSX Corp., Inc., note 1 supra.

(3) Cleveland Indians Baseball Club, Inc., 121 SCt 1433 (200l).

(4) North Dakota State University, 255 F3d 599 (8th Cir. 2001), nonacq., 2001-2 CB xv.

(5) See Regs. Secs. 31.3121 (a)-1(c) and (d), 31.3306(b)-1(c) and (d) and 31.3401(a)-l(a)(2) and (3).

(6) Regs. Secs. 31.3121(a)-1(i), 31.3306(b)-1(i) and 31.3401(a)-1(a)(5).

(7) See note 1, supra.

(8) Rev. Rul. 74-252, 1974-1 CB 287.

(9) See, e.g., North Dakota State University, note 4 supra.

(10) See note 5, supra; Rev. Ruls. 58-301, 1958-1 CB 23 and 74-252, note 8 supra.

(11) Note 4, supra.

(12) Note 1, supra.

(13) See Ronald N. Gross, TC Memo 2000-342.

(14) Edward E. Robinson, 102 TC 116 (1994), aff'd, 70 F3d 34 (5th Cir. 1995), cert. den.

(15) See, e.g., Allen Burditt II, TC Memo 1999-117.

(16) H. Rep't No. 104-586, 104th Cong., 2d Sess. (1996), p. 143.

(17) Arnold Reisman, 248 F3d 1151 (6th Cir. 2001).

(18) Reidar A brahamsen, 228 F3d 1360 (Fed. Cir. 2000), cert. den.

(19) Rev. Rul. 80-364, 1980-2 CB 294.

(20) TRUCKS, Inc., 234 F3d 1340 (11th Cir. 2000).

(21) American Airlines, Inc., 204 F3d 1103 (Fed. Cir. 2000).

(22) Note 3, supra.

(23) HB&R, Inc., 229 F3d 688 (8th Cir. 2000).

(24) Central Illinois Public Service Co., 435 US 21 (1978).

(25) Note 23, supra.

(26) Krawczyk v. Harnischfeger Corp., 41 F3d 276 (7th Cir. 1994).

(27) Licciardi v. Kropp Forge Div. Employees Retirement Plan, 990 F2d 979 (7th Cir. 1993).

Nancy J. Stara, J.D., LL.M., CPA Deloitte & Touche Professor of Accountancy University of Nebraska-Lincoln Lincoln, NE
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Title Annotation:determining what constitutes wages for tax purposes
Author:Stara, Nancy J.
Publication:The Tax Adviser
Date:Mar 1, 2003
Previous Article:Tax shelter Temp. Regs.
Next Article:Current corporate income tax developments .

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