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

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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.

Scenario 1: Settling an ADA and FMLA case that was filed in court.

Mary was terminated from her employment with Company A, a private employer, after taking Family Medical Leave Act (FMLA) leave to treat for cancer and whose disabling condition was not accommodated within a week after her return. After filing a charge of discrimination with the Equal Employment Opportunity Commission (EEOC), Mary filed suit in federal court, alleging claims under the Americans With Disabilities Act (ADA) for failure to accommodate and disability discrimination – claims for failure to accommodate and disability discrimination under Chapter 4112 of the Ohio Revised Code and claims for interference and retaliation under the FMLA. Mary’s complaint asked for the following types of damages: lost wages (back pay and front pay), emotional-distress damages, punitive damages, liquidated damages under the FMLA, as well as attorney fees and costs.

Mary settles her case for $100,000 total. The payment(s) to her will be paid lump sum, with a separate payment of $40,000 to her legal counsel for attorney fees.

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.

Scenario 2: Now, consider a severance situation – with variations.

Mary worked for Company A, a private employer that merged with Company B. As a result of the merger and to eliminate duplicate positions, Mary was laid off as part of a reduction in force that impacted several Company A employees. As part of the layoff, Company A offered a severance arrangement whereby Mary, who was earning $250,000 per year, will receive 26 weeks of severance and continued healthcare under COBRA for the 26-week severance period. Mary does not have any viable discrimination, or other, claims against Company A.

Mary’s $125,000 in severance will be paid out over time, as payroll, starting in November 2024 and ending in May 2025. Mary will elect COBRA and the company will pay the insurance premiums directly to the COBRA administrator.

Variations on the theme: 1) Mary will receive a lump-sum payment in November 2024. She will elect COBRA and the lump-sum payment is meant to cover both the $125,000 in severance, along with the COBRA premiums and/or 2) Mary will pay the COBRA premiums herself and Company A will reimburse her directly for them.

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.

$\"Light$ Practice Pointer: While it may be rare to see a provision like this in a severance agreement, if there is one, an attorney representing the employee should absolutely ask that the employer restructure these payments to ease the tax burden on the client. Otherwise, the client will be subject to withholding and employment taxes on the portion of the severance that is supposed to pay for healthcare. This is not ideal!

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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.

$\"Light$ Practice Pointer: While most claims that we deal with will fall into this definition, there are a few that may not. For example, if you are bringing a defamation claim against a former employer or a tortious interference claim, attorney fees for those may not be deductible. In such a situation, it is good to get outside tax advice as to how the attorney fees are treated for tax purposes.

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.

$\"Light$ Practice Pointer: If possible, try to accrue the fees and wait to bill them until the matter has been resolved. Therefore, there is no timing issue between when the fees were paid and when the settlement proceeds were received. This should not be too difficult in practice because generally, negotiations are wrapped up in a matter of a few months.

*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.

$\"Light$ Practice Pointer: It can sometimes help to advise clients to be fiscally responsible and suggest mechanisms that will help them to help themselves in financial situations, such as a settlement or severance. Therefore, what is the worst thing that could happen if there was too much withholding? They get a bigger refund next year! Not a bad thing. However, what happens if not enough money was withheld, and they owe taxes that they cannot pay? Interest and penalties accrue and the IRS levies against them. What a nightmare. Thus, before seeking to decrease withholding – and therefore decrease the taxes paid in on the settlement or severance – it is best for the client to get tax advice from a professional.

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:

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The short-term deferral exception, or
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The separation pay safe-harbor exception.
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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.

$\"Light$ Practice Pointer: If the client wants to avoid the .9% surtax, and depending on other circumstances, the parties could agree to spread out the payments over two years to keep the payments below the threshold for the surtax. Similarly, if the client wants to maximize Social Security contributions, a large payment spread out over two tax years, where the payments do not exceed that year’s cap, would ensure maximum contributions.

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.

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Here is sample language to include in the payment provisions of settlement and severance agreements.

Going back to the hypotheticals above, consider Mary’s settlement scenario, where there are three checks, one for lost wages, one for emotional distress and a separate check to Mary’s legal counsel. The $100,000 payment to Mary is allocated 50/50 to lost wages and emotional distress and the attorney fees are $40,000.

Here is how this allocation and tax reporting is reflected in the language of the settlement agreement:

In consideration for this Agreement, the Company shall pay Employee the total sum of One Hundred Thousand Dollars and Zero Cents ($100,000.00) (“Settlement Sum”). The Settlement Sum shall be paid as follows:

i. One check shall be made payable to Employee in the amount of Thirty Thousand Dollars and Zero Cents ($30,000.00), less required withholdings, and representing alleged wage damages for which the Company shall issue Employee an IRS Form W-2;

ii. One check shall be made payable to Employee in the amount of Thirty Thousand Dollars and Zero Cents ($30,000.00), with no withholdings, representing alleged non-wage compensatory damages for which the Company shall issue Employee an IRS Form 1099-MISC, with this amount reported in box 3; and

iii. One check shall be made payable to Employee’s Counsel in the amount of Forty Thousand Dollars and Zero Cents ($40,000.00), representing attorney’s fees and costs for which an IRS Form 1099-MISC shall be issued.

If the parties agree that the employer will tax the wage portion of the settlement at the supplemental rate, here is a variation in the language to use:

One check shall be made payable to Employee in the amount of Thirty Thousand Dollars and Zero Cents ($30,000.00), less required withholdings, with federal withholding set to the supplemental rate, and representing alleged wage damages for which RELEASEES shall issue Employee an IRS Form W-2.

Shifting gears to the severance scenarios, the issue here is whether the severance will be paid lump sum or periodically, in accordance with the company’s payroll schedule. Here is language for a severance that is paid out over time, and where the employer pays the COBRA premiums directly:

The Company agrees to pay Employee 26 weeks of special separation pay (“Severance Payments”) in the total amount of One Hundred Twenty-Five Thousand Dollars and Zero Cents ($125,000.00), less legally required deductions. The Severance Payments will be paid bi-weekly, in a manner consistent with the Company’s payroll schedule.

The Employee’s coverage under the Company’s medical, dental, and vision plans will continue through the Severance Period. During this time, and assuming that Employee makes a timely election for continuation coverage under COBRA, the Employer will pay the Employee’s COBRA premiums directly to the COBRA administrator.

Here is language for a situation where the employee pays the COBRA premiums herself and seeks reimbursement from the employer:

The Company agrees to pay Employee 26 weeks of special separation pay (“Severance Payments”) in the total amount of One Hundred Twenty-Five Thousand Dollars and Zero Cents ($125,000.00), less legally required deductions (“Severance Payments”). The Severance Payments will be paid bi-weekly, in a manner consistent with the Company’s payroll schedule.

Should the Employee elect to continue her healthcare coverage under COBRA, Employee shall pay the COBRA premiums for which the Company shall reimburse her, upon receipt of proof that the payments were made.

At the end of the day, although most employment lawyers are not tax lawyers or tax professionals, it is imperative that we at least recognize the tax issues that can arise in our cases and, if we are unable to provide our clients with at least some advice on these matters, it is incumbent upon us to get to the hands of a competent tax advisor, whether an attorney, an accountant – or both!

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Christina M. Royer is a partner with Employment Law Partners LLC located in Independence, Ohio.

Lesley A. Weigand is a partner with the firm of Stark & Knoll Co. LPA located in Akron.

Faith C. Whittaker is a partner with the firm of Dinsmore & Shohl LLP in Cincinnati.

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