I Am Not a Tax Lawyer and I Don’t Play One on TV

What employment lawyers need to know about tax issues in settlement and severance agreements

As employment lawyers, when we settle a case or assist a client with a severance arrangement, we cannot draft settlement or severance agreements “in a vacuum.” Because these arrangements invariably involve the payment of money from an employer to an employee, when we draft language in these agreements, we must be mindful of the tax implications of the provisions we’re including. As much as we would like to be creative – and we can be, for sure! – we don’t want to inadvertently walk our clients into problems with the IRS or an unanticipated tax burden.

The easiest way to illustrate the common tax issues that can come up in employment cases is to filter hypothetical settlement and severance scenarios through the lens of a tax lawyer so that we can be sure that we are dotting all the I’s (for IRS) and crossing all the T’s (for taxes) in putting together these agreements.

How should Mary’s $60,000 be allocated in the settlement agreement? How should the payment(s) to her and/or her counsel be reported to the IRS?

Remember, ask yourself this question: “In lieu of what were these damages paid?”  

1. While many clients and attorneys would like the answer to be “emotional distress” and/or “personal physical injuries” or something along that line, to prevent the award from being subject to employment taxes or, in the case of physical injuries, to make the award non-taxable under IRC §104(a), this is just not realistic in the context of an employment claim, especially where the complaint states that Mary did return to work and was let go because the employer could not accommodate her. Therefore, we need to look at what is most realistic.

2. The most typical type of recoverable damages in employment cases is wage-based, such as back pay and front pay. Back pay and front pay are subject to withholding (federal, state and local), then also subject to employment taxes (FICA, FUTA, Medicare), in addition to employer match. A W-2 should be issued to the employee to report any wage-related settlement or damage awards.

3. What about any claimed emotional distress and what if the client actually does suffer some kind of physical harm relating to the emotional distress? The primary question is whether there are medical bills to support a claim.

A. If yes, is there a medical insurance subrogation issue that we need to be concerned about? (That might be worse than being taxed, given the administrative headache of subrogation!)

B. What evidence came out in the case about the physical manifestations of Mary’s emotional distress? For example, maybe Mary suffered from migraines, stomach issues or some other physical manifestation of emotional harm?

C. At the end of the day, both the employee and the employer need to be ready to justify any dollar amount attributable to physical manifestations of emotional distress, and there definitely needs to be supporting documentation or testimony. If there is only a claim of bad headaches, sleepless nights, or gastrointestinal disturbance (while all of those are definitely bad and quite painful), it is best to be sensible and not strike the conscience of the IRS. Remember, the goal is to stay under the radar of the IRS.

D. Generally speaking, it is best to allocate a settlement, or portion of a settlement, to personal, physical injury only where the facts of the case warrant it, such as an egregious case where there is a physical assault that resulted in injuries.

E. In most employment cases, emotional distress is “garden variety,” so it is taxable to the client, although not subject to employment taxes. This type of payment is not subject to any withholdings and is reported on Form 1099-MISC, in box 3.

4. Punitive damages and liquidated damages are always taxable.

A. Here, because Mary is settling her claim, it is not going to be tried before a trier of fact, so there would not be an award of punitive damages, per se. Therefore, no defense attorney is going to agree to any amount for punitive damages or liquidated damages because any wrongdoing is specifically denied and the case is being settled.

B. In this context, there is really no point to allocating any part of a settlement to punitive damages or liquidated damages. Any damages claimed beyond lost wages can be characterized as emotional distress or non-wage compensatory damages, which are taxable (see above).

C. However, changing the facts slightly, what happens if the case went to a jury and there were a jury verdict in favor of the plaintiff and punitive and liquidated damages were awarded? Consider then a settlement upon appeal. In that instance, a portion of the settlement could be allocated to punitive damages and liquidated damages as long as the underlying amount for lost wages was paid in full. In that instance, the punitive and liquidated damages would be reported on Form 1099-MISC, in box 3.

What are the tax implications of Mary’s severance arrangement?

A. If her severance is paid out over time with healthcare premiums paid directly to the healthcare provider, straddling two tax years:

1. The cost of the healthcare premiums is not taxable to Mary because those costs are paid directly by the employer for her health care.

2. The wages are reported on W-2 over a period of two years that the severance is received.

B. If her severance is paid out in a lump sum that covers both severance pay and COBRA premiums:

Unfortunately, a bad result here. See Adkins v. United States of America, 693 F. Supp. 574 (N.D. Ohio 1988) (Dowd, J.). Judge Dowd, in his opinion, explained that when a lump sum is received, the employees can do anything they want with the funds, they do not have to be used for health care premiums. Contrast that with the below scenario. The entire lump sum – which includes both severance pay and health care premiums – would therefore be subject to withholding and employment taxes and reported on a W-2.

C. If Mary pays the COBRA premiums herself and the company reimburses her for them:

The reimbursement for the healthcare premiums is not taxable to Mary and therefore not reported. The reason these payments are not taxable is because they are readily identifiable and easily calculated. See Adkins, citing Rev. Rul. 61-146, 1961-2 C.B. 25.

If the employer were to pay Mary a lump sum up front, which she could then use to pay for health care premiums, that amount would be subject to withholdings and reported on Form W-2.

What about attorney fees paid to the employee’s counsel?

The reporting and taxation of attorney fees depends on whether they are paid as part of a contingent-fee arrangement and whether they are paid hourly, and whether the employee’s claims are considered “employment discrimination claims” under the Internal Revenue Code (IRC). Let’s start with contingent fees earned, most typically in a settlement scenario:

1. Attorney fees are required to be reported to the employee. The employee should receive a 1099-MISC with the fees reported in box 10 (2024 form).

2. As long as the nature of the claim falls into the statutory definition of an “unlawful discrimination claim,” the employee is permitted an above-the-line deduction for these fees on Form 1040, Schedule 1, line 24(h), so the net effect is that the employee is not taxed on the attorney fees paid to his or her attorney.

3. IRC §62(e) sets forth a laundry list of what the IRS defines as “unlawful discrimination.” Note that this definition is different from how employment lawyers may view what is considered unlawful discrimination.

4. Of particular note though is IRC §62(e)(18), which is the catch-all provision and allows an above-the-line deduction for the following:

Any provision of Federal, State or local law, or common law claims permitted under Federal, State or local law (i) providing for the enforcement of civil rights, or (ii) regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.

This catch-all provision covers the waterfront. In the tax code itself, any claim about employment is actually defined as an unlawful discrimination claim, thus allowing the above-the-line deduction.

5. Technically speaking, the employee then should issue a 1099-MISC to his or her attorney. In reality, that will never happen so in practice, the employer issues a check for the attorney fees directly, per the settlement agreement. The attorney should receive a 1099-MISC from the employer as well, with the fees reported in box 10.

6. Clients should take their settlement agreement and the attorney’s fee invoice to their tax preparer so that their tax preparer can properly deduct the attorney fees on the proper line of the 1040.

7. Clients should also tell their CPA that they received an employment settlement and explain that the attorney fees are deductible. It has greatly helped that there is now a line item on Form 1040, Schedule 1, line 24(h) to deduct the attorney fees above the line so even those tax preparers who may not be familiar with this scenario should be able to figure it out.

8. Also, the employee’s counsel should ask their clients who their tax preparer is and tell them this is not the year to go to H&R Block. (Nothing against H&R Block, but an employment settlement is an anomaly and not something these mass producers of returns see every day).

So what happens if the employee’s counsel charges her client hourly, which can happen in settlement negotiations and is quite common in severance situations?

1. If the fees are paid in the same tax year that the settlement is reached, it is the exact same scenario as in contingent-fee arrangements, except that the employer would not issue a 1099 to the employee (because the employer did not pay the fees to the attorney, the employee did).

2. However, if the attorney bills monthly and the representation spans over two tax years, then the fees that have been paid for the prior period cannot be deducted on line 24(h) of Schedule 1. Here is the nuance with how deductions work: Deductions are taken in the year in which they are paid. However, there is no resolution (i.e. payment) in those prior periods to take those fees against.

*A small catch-22 arises when a settlement is negotiated at the end of the year. If the client will receive the payment by Dec. 31, then the attorney fees must be paid by Dec. 31 to be deductible.

**Another option is to ask the client to pay the attorney fees with their credit card by Dec. 31 (and utilize the float) or just pay the fees from other assets but pay it by Dec. 31. If there are client funds in IOLTA to pay the client’s bills, ask the client for permission to bill them, and move the funds to the firm’s operating account by Dec. 31.

3. In this scenario, clients should take the severance agreement, the attorney-fee invoice and proof of payment to their CPA and explain that these fees are deductible on Form 1040, Schedule 1, line 24(h). If there are questions, the CPA can call the attorney.

Is there any way to control, or limit, the increased federal withholding that may result from a large, lump-sum payment?

Going back to Mary’s settlement hypothetical, she will receive a lump-sum payment of wages that likely far exceeds the pay she would usually receive in a given pay period. As a result, the federal withholding rate on this lump sum will be very high. This is because most payroll systems assume that the employee earns the lump-sum amount each pay period and adjusts the tax rate accordingly.

In some cases, the employee may be able to submit a new W-4 to the employer and adjust her exemptions; the higher the exemptions, the less tax is taken out. Employers cannot adjust withholding without a new W-4. However, as employment lawyers, it is best not to get into the client’s personal tax situation.

If the client needs advice on how to fill out Form W-4, the best advice is to tell them to consult with their CPA. There are many variables that go into withholding, not least of which are other sources of income the employee has and/or what has already been paid in via estimated payments throughout the year.

Another way to try to reduce, at least somewhat, the federal withholding on a large lump-sum payment is to get the employer to agree to set withholding at that year’s “supplemental” or bonus rate, which is a flat tax rate for payments under $1 million. For 2024, the supplemental rate is 22%. If the parties agree to this, it should be captured in the agreement (sample language later in this article!).

Are there any tax implications relating to confidentiality provisions?

In 2018, in the wake of the #MeToo movement, we were all talking about the “Weinstein” amendment, which did not allow employers to take a tax deduction for any settlements of sexual harassment claims where there was a confidentiality, or non-disclosure, clause. This rule is still in place however, it is not discussed as much these days. Now, the “hot topic” with confidentiality arises from recent rulings by the National Labor Relations Board – a subject for a different article!

Should we be afraid of Section 409(A)?

The general rule is that severance benefits are a form of deferred compensation subject to Section 409A unless an exception or exemption applies. There are timing issues that need to be reviewed and adhered to in order to avoid the implications of 409A.

There are two main ways in which separation pay can be structured consistent with Section 409A. First, the separation pay can be structured to avoid Section 409A – meaning structured so that it does not fit the definition of deferred compensation subject to Section 409A at all. This can be done by structuring the payments to fit within one of the following exceptions to what is considered deferred compensation:

• The short-term deferral exception, or

• The separation pay safe-harbor exception.

Under the short-term deferral exception, payments made not later than two and one-half months after the end of the year in which a “substantial risk of forfeiture” lapses (or stated another way, “after the right to payment vests”) are not deferred compensation. On the other hand, the separation pay safe harbor is available for separation pay that is paid only in the case of an involuntary termination and that does not exceed, in the aggregate, the lesser of twice the employee’s annualized compensation for the previous calendar year, or twice the compensation limit in IRC §401(a)(17). In 2024, the limit is $345,000, so twice would be $690,000.

While it is not likely that Section 409(A) would be implicated in most severance arrangements, employee counsel should seek tax advice on this issue – or advise the client to do so – if it does appear that it could arise.

Is there anything we should be telling our clients about Medicare and Social Security taxes?

Social Security and Medicare deductions, and the employer’s match of these deductions, (FICA) can become an issue for high-wage earners or for settlements in which the wage payment is large. Social Security is deducted – and matched – on wages that do not exceed a cap that increases each year. In 2024, the cap is $168,000 and will increase to $174,900 for 2025. This means that, if a client receives a severance or wage payment in a settlement that exceeds the cap amounts, Social Security will be deducted only from wages paid, up to the capped amount.

While Medicare has no cap or threshold, like Social Security does, there is a “surtax” that can be due on annual wages of $200,000 or more for single filers. Generally, Medicare tax is a flat 1.45% of wages. However, for amounts that exceed $200,000, an “extra” .9% is owed. Employers are responsible for deducting and remitting any surtax owed.

What about tax indemnification? If I represent an employer, do I need it? If I represent an employee, should I fight about it?

Employers generally insist on tax indemnification to ensure they do not have an issue later on with the designation of any amount that is paid to the plaintiff/claimant that is not characterized as wages and that is not treated like payroll.

Employee-side attorneys often resist tax indemnification but, with proper drafting, there are ways to compromise here that do not harm the client and should not interfere with the settlement or severance arrangement. Employees can agree to indemnify a former employer if some liability arises based on how the employee treats the payments for tax purposes.

However, employees should never indemnify a company for the employer share of FICA taxes. For example, if the IRS determines that the amount allocated to emotional distress should have been treated like wages, the employee will be on the hook for the withholding that was not paid, but the employer will be on the hook for its share of FICA (i.e. Social Security and Medicare matching taxes).

Here is sample language for an agreement that represents both sides’ interests fairly:

The parties agree to indemnify and hold each other harmless for any tax liability, together with any interest or penalties assessed thereon, which Employee and/or RELEASEES may be assessed by the United States Internal Revenue Service, or any state or local department of taxation, arising from the other party’s tax treatment of the payments made to Employee pursuant to this Agreement, with the exception of the employer’s portion of any applicable withholding, for which the Company shall be responsible.