TAX IMPLICATIONS AND PRACTICAL IMPACTS OF DAMAGES IN EMPLOYMENT CASES

Brian Jorgensen | Jones Day | 2727 N. Harwood Street Dallas, Texas 75201 | (214) 969-3741 | bmjorgensen@jonesday.com

Stephen Harris | Jones Day | 2727 N. Harwood Street Dallas, Texas 75201 | (214) 969-5277 | sgharris@jonesday.com

Why Is This Important?

• Improper tax treatment can cause problems with IRS and taxing authorities.

• Can affect the direction of settlement discussions. • Key issues:

• Is the payment gross income? • Does the payment constitute wages? • Can the payor deduct the payment as trade or

business expense or production of income expense?

• Can the payment be capitalized?

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The “Origin of the Claim”

• The tax treatment of damages received in a settlement or award is inextricably tied to the claims giving rise to it and their merits. U.S. v. Gilmore, 372 U.S. 39 (1963).

– What is the dispute about? – Why is plaintiff receiving all this money?

• The complaint is the starting point and the underlying claims determine tax treatment.

The “Origin of the Claim”

• Most settlement and award payments (unless excluded by IRC § 104(a)(2)) are treated as gross income to the recipient. The nature of that income is determined based on the nature of the underlying claims giving rise to the payments.

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Tax Treatment of Damage Components:Different Elements; Different Tax Regimes

• Backpay: Generally Treated as Wages• Subject to FICA and income tax withholding.• Reported on IRS Form W-2. • But see Newhouse v. McCormick (8th Cir 1998) –

FICA and income tax withholding require an actual employment relationship.

• Front Pay: Generally Treated as Wages• Subject to FICA and income tax withholding.• Reported on IRS Form W-2.• But see Dotson v. US (5th Cir 1996) – only backpay

portion of a settlement is wages.

Tax Treatment of Damage Components:Different Elements; Different Tax Regimes

• Title VII, Texas Labor Code, etc.

• Wages taxed as compensation for services.

• Subject to FICA and income tax withholding.

• Reported on IRS Form W-2.

• Age Discrimination (ADEA)/Fair Labor Standards Act (FLSA)

• Wages taxed as compensation for services.

• Liquidated damages: ordinary income but not wages.

– Not subject to withholding.

– Reported on IRS Form 1099.

Tax Treatment of Damage Components:Different Elements; Different Tax Regimes

• Compensatory Damages

• Not taxable if paid on account of physical injury or sickness.

• Taxable if not paid on account of physical injury or sickness.

• If taxable then reported on IRS Form 1099.

• Punitive and Liquidated Damages

• Taxable regardless of underlying cause.

• Reported on IRS Form 1099.

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Tax Treatment of Damage Components:Different Elements; Different Tax Regimes

• Torts: Personal Physical Injury

• IRC § 104(a) excludes “the amount of damages (other than punitive damages) received . . . on account of personal physical injuries or physical sickness.”

– Exclusion limited to physical injury and any emotional distress caused by physical injury (physical consequences not enough).

– IRS’s position: must be “observable or documented bodily harm” (e.g., bruising, cuts, swelling or bleeding). CCM 2009-035

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Tax Treatment of Damage Components:Different Elements; Different Tax Regimes

• Emotional Distress, Harm To Business Reputation

• Treated as ordinary income (generally not excluded from income).

• Not subject to withholding; reported on IRS Form 1099.

• May be excluded to the extent claimant has incurred medical expenses for treatment of emotional distress.

• But see Domeny v. Commissioner, T.C. Memo 2010-9.

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Tax Treatment of Damage Components• Recent Development: Severance Payments

• IRS treats as wages under Regs. § 31.3401(a)-1(b)(4).

• Michigan District Court holds to the contrary in U.S. v. Quality Stores, 1005 AFTR 2d 2010-1110 (W.D. Mich. 2010) (calling severance non-taxable wage replacement social benefits).

• But see CSX Corp. v. U.S., 518 F.3d 1328 (Fed. Cir. 2008).

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Hybrid Cases: Allocation Matters

• Allocating damages among multiple components of the settlement or award is crucial.

• What does the complaint / record say?

• What claims would a court find credible if the dispute were tried?

• What types of damages does the applicable statute allow?

• What is the relationship between the damage payment and the claimant’s regular compensation?

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The Allocation: Facts Matter

• Are the allocations reasonable?

• What happened?

• What do the facts, viewed disinterestedly, suggest?

• Emotional Distress Components

• Is this a throwaway claim or a real concern?

• What do the facts, viewed disinterestedly, suggest?

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Employer’s Responsibilities

• Withholding and paying over income and FICA tax, paying employer share of FICA tax, on all damages properly treated as wages.

– Penalties for non-compliance.

• Correct reporting of wage and non-wage compensation on the appropriate IRS form.

– Penalties for non-compliance.

• Do not rely on plaintiff indemnity (“We’ll handle the taxes and indemnify you.”)

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Other Notable Wages Issues

• Wages are treated as earned in year paid for FICA purposes, not when services provided.• U.S. v. Cleveland Indians Baseball Co.,

532 U.S. 200 (2001).• Circuits split on whether compensation in

failure to hire cases is wages.• Newhouse v. McCormick & Co., 157 F.3d

582 (8th Cir. 1998).• Melani v. Board, 814 F.2d 6563 (2nd Cir.

1987)

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Attorney’s Fees

• Attorney’s fees are:• Generally income to the plaintiff

– Commissioner v. Banks, 543 U.S. 426 (2005) • Deducted “above the line” in discrimination cases

– IRC §§ 62(a)(20), 62(e)• Not wages under current law (but see Rev. Rul. 80-364) • Generally reported twice

– as income to the plaintiff (Regs. § 1.6041-1(f))– as income to the plaintiff’s attorney (Regs. § 1.6045-5)

• Penalties for non-compliance– up to 20% of settlement under IRC §§ 6721, 6722

Example (Proposed Language)• A check made payable to Employee in the amount of ten

thousand dollars ($10,000) for her wage claims (with respect to which, Employer will make the appropriate withholdings and will issue the appropriate W-2 form);

• A check made payable to Employee in the amount of two thousand dollars ($2,000 for her non-wage claims (with respect to which, Employer will issue the appropriate 1099 form);

• A check made payable to Employee’s attorneys for attorney’s fees in the amount of three thousand dollars ($3,000) (with respect to which Employee will issue an IRS form 1099 form to Employee and Employee’s attorneys).

Considerations In Class Action Cases

Attorneys’ Fees In A Class Action Context

• Attorney’s fees are not income to the class members in an “opt-out” class action.

• Not so for “opt-in” actions in which claimants can all be identified.• Rev. Rul. 80-364.• Sinyard v. Commissioner, T.C. Memo 1998-364.

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Expenses Deductible When “Economic Performance” Occurs

• Defense of business costs are generally deductible; exception for fines and penalties.

• Costs, however, are deductible only when amounts are actually paid to the claimant.• Regs. § 1.461-4(g)(2)

• Payment to a trust or fund generally does not constitute payment to the tort claimant.

• Delay in deductions lowers their value, increases after-tax cost of settlement.

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Use of “Qualified Settlement Fund” to Accelerate Deduction

• To address this concern, parties may use a Qualified Settlement Fund (“QSF”).

• Requirements for a QSF:• Settlement approved by and implemented

under continuing jurisdiction of court or other governmental authority.

• Payment resolves or satisfies qualifying claims.

• Payment is made to a trust or funds are otherwise segregated from defendant’s other assets.

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“Resolve or Satisfy”

• QSFs may be used to resolve• Claims arising out of tort, breach of contract, or

violation of law• CERCLA claims

• QSFs cannot be used to resolve • Workers’ compensation claims• Self-insurance claims• Warranty claims• General creditor claims

Benefits of QSFs to Defendants

• Immediate deduction on payment of funds to the trust even though plaintiffs may not receive the money for years.

• Release of liability from the court.

• No information reporting or tax withholding responsibilities since payment is not being made to plaintiff.

Benefits of QSFs to Plaintiffs

• Delay recognizing income until distribution is made from the QSF.

• Freedom to arrange affairs without the involvement of defendant.

– Plaintiffs are able to negotiate tax language and reporting requirements in a separate agreement with the QSF, and not defendant.

• Time to work out details of distributions, structure attorney’s fees, etc.

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Procedural Aspects of QSFs

• Require an “administrator.”• Regs. § 1.468B-2(k)(3).

• Taxed on investment income at trust rates.• Regs. § 1.468B-2(a).

• File own tax returns and provide claimants with any required information return (e.g., 1099s).• Regs. §§ 1.468B-2(k)(1), -2(l)(2).

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Concluding Thoughts

• Tax matters when negotiating settlements.

• Tax results can be strange.

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Questions?

DLI-6350361 v. 1

Brian Jorgensen Jones Day 2727 N. Harwood StreetDallas, Texas 75201(214) 969-3741bmjorgensen@jonesday.com

Stephen Harris Jones Day 2727 N. Harwood Street Dallas, Texas 75201(214) 969-5277 sgharris@jonesday.com