Tax Treatment for Employee Litigation Settlements

The IRS recently issued Chief Counsel Advice (CCA) Memorandum 20133501F, which addresses the appropriate tax treatment for litigation settlements with current or former employees.  The guidance was as follows:

  • “When are attorney’s fees paid by an employer as part of a settlement agreement with a former employee subject to employment taxes?

In the absence of a specific allocation for attorney’s fees in these settlement agreements, attorney’s fees paid by an employer as part of a settlement agreement with a former employee, which are includable in income, are subject to employment taxes to the extent they are wages attributable to an employment-related claim. The Service’s position is that payments constituting severance pay, back pay and front pay are wages for employment tax purposes.

  • What are the information reporting requirements for attorney’s fees paid by an employer pursuant to a settlement agreement with a former employee?

The appropriate information reporting requirements depend on the facts and circumstances of each case. Unless the attorney’s fees are specifically allocated in a settlement agreement, the payments made in settlement of wage-based claims are generally considered wages that are required to be filed and furnished to the employee on Form W-2, Wage and Tax Statement. If the attorney’s fees are specifically allocated, 
they are generally required to be filed and furnished to the employee on Form 1099-MISC, Miscellaneous Income. The reportable amounts are always filed and furnished to the attorney on Form 1099-MISC.

  • What penalties can be asserted if an employer fails to comply with reporting requirements for attorney’s fees paid as part of a settlement agreement with a former employee?

An employer that fails to file and furnish correct information returns that report attorney’s fees paid as part of a settlement agreement may be subject to penalties under §§ 6721(a) and 6722(a) of the Internal Revenue Code.5 If the employer intentionally disregarded the reporting requirements, the penalties increase under
§§ 6721(e) and 6722(e).”

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