In employment cases, the structure of settlement payments may have significant tax consequences for clients. Often the tax consequences depend on whether the settlement payments are for loss of income damages, which are taxable, or emotional distress types of damages, which are not.
Wage and hour mediation settlements, especially in California, may involve somewhat different considerations. In those cases, emotional distress types of damages often play less of a role. More often, the tax issues relate to whether the payments are allocated to wages or to penalties or other types of non-wage payments.
Some General Considerations
Settlement payments to an employee are often reported to taxing authorities in one of two ways. Wages and other types of payments considered to be wages are usually reported by a W-2 form issued by the employer. Non-wage payments are reported by the employer issuing a form 1099. The type of form used can have significant tax consequences for both parties for such things as Medicare taxes and self-employment taxes.
On the employee's side, payments for wages, reportable through a W-2 form, often are subject to withholding by the employer. If the payments are not for wages and are reported via a form 1099, the employer does not withhold taxes from the settlement payment. The employee receives more cash up front but is responsible for payment of Medicare and other types of self-employment taxes that may apply to non-wage income.
The classification of settlement payments may also have significant tax consequences for employers. Payments for wages are subject to withholding obligations. Wage payments can also give rise to obligations to pay payroll taxes and possibly to retirement plans. Settlement payments for penalties might not be deductible.
Sometimes it is not clear how the taxing authorities will treat payments for certain types of claims. For example, payments for lost meal and rest breaks may be treated as wages, but waiting time penalties might not.
Tax rules evolve over time and vary by jurisdiction. The rules can be complex and may not be known on the day of a mediation. Therefore, it is important to know the current rules before the mediation starts so you can accurately evaluate the consequences of a settlement offer.
Knowing the tax consequences can also help to maintain good client relations. On the employee side, clients are often solely interested in what they will be receiving and may not understand how taxes will change their net recovery. Also, if they are not used to paying specialized types of taxes, they may need to know how to deal with any tax obligations created by a settlement.
Employers need to plan too. The payment of wages may require an employer to pay additional amounts to taxing authorities beyond what is merely withheld from an employee's paycheck. An employer that is not familiar with wage and hour litigation might well be unhappy if it later realizes that the settlement payments created the obligation to pay additional amounts to taxing authorities for payroll taxes, etc.
Planning can prevent a lot of these problems. An employee may not be able to later fund a surprise tax obligation. An employer might be able to analyze the tax consequences of potential settlement structures before the mediation and determine their true cost. It might also be able to ascertain if a certain structure might provide some unusual tax benefits. Planning can help attorneys on both sides have satisfied clients who are not unpleasantly surprised by the tax consequences of a settlement.
One good way to plan is to develop a simple checklist of topics to consider before finalizing your mediation strategy for an employment law dispute. It could include the following:
- Determine what types of damages or penalties might be recovered.
- Learn the tax consequences of payments received or made under those categories.
- Determine if there are other consequences, such as payment of self-employment taxes or more payroll taxes, if payments are received or made for the various types of recoveries.
- Apply this analysis to determine what you think will be the maximum gross recovery or payment.
- Calculate the maximum net recovery or payment.
Finally, discuss possible settlement structures with your client. Nobody likes last-minute surprises, and people are more likely to make good decisions if they have enough time to think through all the issues.
Originally published May 18, 2023
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.