The IRS Counsel Memorandum helps taxpayers understand how the IRS may determine the tax treatment of employment-related settlement payments. It outlines both the income and employment tax consequences, as well as the appropriate reporting, of settlement payments in four steps outlined below:
Step One: Determine the Character of the Payment
The first step of determining the character of the payment being made for income tax purposes is important in deciding whether a payment is ultimately taxable and whether a payment constitutes "wages" for employment tax purposes (steps two and three in the four-step process). The IRS outlined the most common types of judgment and settlement payments made in connection with employment-related disputes. This includes severance pay, back pay, front pay, compensatory damages, consequential damages, punitive damages and restoration of benefits. In addition, the IRS Counsel Memorandum also lists and describes some of the statutes under which employees (or former employees) might bring lawsuits, such as Title VII of the Civil Rights Act of 1964, the Age Discrimination in Employment Act (ADEA) of 1967, the Americans with Disabilities Act of 1990 (ADA), state statutes and common law wrongful termination.
Step Two: Determine Whether the Payment is Taxable
The IRS notes that damages recovered from an employment-related dispute are generally not recoveries for a personal physical injury where 104(a)(2) provides a taxability exception. Therefore, the most difficult questions are usually whether the amounts are wages for employment tax purposes (Federal Insurance Contributions Act (FICA) and income tax withholding), the proper reporting of the amount for Form 1099 or Form W-2, and reporting of attorneys’ fees on Form 1099. Regarding attorneys' fees, the IRS Counsel Memorandum cites Commissioner v. Banks (543 U.S. 426 (2005)), in which the Supreme Court ruled that a claimant generally must include the entire amount of a taxable judgment or settlement in gross income, including any portion paid to an attorney as a contingent fee. Attorneys will generally need to have a fee arrangement in place at the time of settlement which provides for the structuring of payments solely from the claimant’s settlement proceeds.
Structuring of attorney fees could have important legal and tax consequences, particularly when you consider that The Jobs Act, signed by President George W. Bush on October 22, 2004, allows an above-the-line deduction for amounts attributable to attorneys' fees and costs received by individuals based on claims brought under the False Claims Act, section 1862(b)(3)(A) of the Social Security Act 34 or unlawful discrimination claims, which are covered under numerous statutes. Attorneys should consult with their own tax and legal advisors prior to agreeing to structure legal fees to determine the tax and other legal consequences.
Step Three: Determine Employment Tax Treatment
The IRS Counsel Memorandum discusses general rules for income tax withholding in connection with common types of settlement payments for employment-related disputes, and discusses the appropriate reporting for each payment, noting that a judgment or settlement payment may comprise multiple elements, each of which may or may not be wages. This could include back pay, emotional distress damages and interest. The determination is made by considering all facts and circumstances, including the remedies available for the claim.
Step Four: Determine Appropriate Reporting
Finally, the IRS Counsel Memorandum lays out the reporting requirements for employment-related settlement payments, including wage reporting, special reporting requirements for back pay, Form 1099 reporting and payments to attorneys.
Using a non-qualified structured settlement assignment
Several documents need to be completed by employment counsel and/or tax advisors in cooperation with the structured settlement broker to receive the correct tax treatment for a periodic payment settlement via a non-qualified structured settlement assignment.
- The Settlement Agreement specifies the parties to the agreement (i.e., the plaintiff, defendant, etc.), the payment schedule, including payments due at the time of settlement, as well as the periodic payments to be made to the plaintiff. If a settlement is being structured, annuity payments must begin within one year, be substantially equal, and be paid out in regularly scheduled intervals at least annually. The settlement agreement also specifies any attorney’s fees included in the settlement and identifies the governing law for the agreement and other contractual obligations for the parties for the settlement.
- Non-Qualified Assignment and Release document (which includes the settling parties plus the assignment company and life insurer) will match the settlement agreement, but it also includes important rights and duties for the parties with regards to the annuity.
- Additional documents required by an insurer include:
- an application for the non-qualified structured settlement annuity - where payee and beneficiaries are established;
- a W9 and a W4P form for tax reporting;
- a proof of birth document - if payments are paid out for the remainder of the life of the payee; and,
- depending on the complexity of the case, additional documents could include court orders, trusts and guardianship documentation.
How Payment Amounts are Determined
There are several factors that come into play in calculating the payout of the structured settlement including the employee’s age and gender (if applicable), which will factor into their expected life expectancy. While payments can cover a claimant’s entire lifespan, they could also choose to be paid out over just 5 years, 10 years or any other term. Any remaining payments, should they pre-decease the end of the term, would go to their named beneficiaries and generally avoid the probate process.7
The claimant will also need to consider how much to structure. While wages can never be structured, the amounts due for other damages including emotional distress will be included in their ordinary income in the year they receive it. If the payments are paid at the same time as the wages, it could push up a claimant’s onetime award into the highest marginal tax brackets. A structured settlement provides a fairer way for the plaintiff to receive their funds over time, where there are no wages and the claimant could potentially continue to be taxed at their typical marginal income bracket.