E. Tax Ramifications Of Structuring Settlements

No matter how carefully employers run their businesses, many companies face the prospect of paying settlements or court-ordered judgments as a result of legal actions brought by former employees. These payments arise from various causes of action such as claims for race, age or sex discrimination, wrongful discharge, defamation, and breach of contract, among others. Besides payment for traditional com- pensatory damages, portions of these settlements or court-awarded judgments often go to cover the employee's attorney fees, costs and dis- bursements, interest, mental and emotional distress, and punitive damages.

The tax consequences of employee-related court awards and settlement payments present many opportunities for companies since properly structured settlements can save companies money while putting more after-tax dollars into an employee's pocket. Employers can avoid common pitfalls in this area and, by following certain strategies, decrease the chances that the proposed settlement or judgment (which has been structured to your company's benefit) will be disturbed by the IRS.

According to the IRS, money received by a judgment or settle- ment, in a lump sum or periodic payments as damages for personal injuries, emotional pain, suffering, inconvenience, mental anguish, loss of enjoyment of life, and other non-pecuniary losses or sickness (such as in a sex harassment case) is not taxable. On the other hand, any money paid to an employee in settlement or judgment as compensation for lost wages, back pay and front pay, severance payments or fringe benefits is subject to withholding taxes. If such money is paid in lost wages, then the employer is required to withhold income taxes and FICA taxes from the payment. The employer would also be required to pay additional sums for FUTA and the employer's portion of FICA.

The potential liability to companies here arises when the IRS finds that the parties improperly treated an amount paid as excludable income (i.e., for pain and suffering) or non-wage income. In such cases, employers are liable for the employee's failure to pay FICA and income taxes together with interest and penalties unless the IRS can receive the amounts owed from the employee. Such penalties may also be assessed against certain corporate officers if the employee fails to pay said amounts. But note that the employer's portion of FICA taxes as well as FUTA tax cannot be paid by the employee and thus the employer is always liable for these taxes.

Furthermore, the United States Supreme Court ruled that employers are required to treat some portion of settlement proceeds in discrimination cases as taxable lost wages and make deductions from the proceeds regardless of whether the discrimination claimant is a current employee.

A company is allowed to deduct the portions of attorney fees and interest spent defending the interests of its business. This applies particularly to contesting demands made by the terminated worker for wages for breach of contract. Conversely, attorney fees incurred by an ex-employee to prosecute his/her alleged defamation of character claims are not deductible, since money received for such claims is for personal injuries and is therefore excludable from being taxed. This includes.findlaw punitive damages and damages arising from wrongful discharge claims.

After understanding what is and is not tax deductible, you may then design the settlement to produce tax advantages for both the company and the employee. As the following example shows, the advantage comes from allocating legal fees, interest and related expenses in a way that increases the tax exemption for both parties. Once you know what you want to do, be sure to put all settlements in writing with specific allocations for specific payments. Identifying the underlying basis for any payments can help avoid problems with the IRS.

TIP: The IRS is not bound by any allocation but it may be honored if it is reasonable. Understandably, the IRS will look with suspicion upon attempts by the parties to diminish their tax liability, such as amending a complaint in a lawsuit just prior to settlement to eliminate or decrease a demand for back pay.

For example, when settling a firing with sex discrimination ramifications, instead of paying $50,000 in back pay or severance, try to structure the settlement in terms of attorney fees, interest, liquidated damages and back pay. Assume this is allocated as follows: attorney fees, $10,000; interest, $2,000; back pay, $30,000; and liquidated damages, $8,000. By structuring the arrangement in this fashion, the parties would eliminate the need to pay FICA and FUTA taxes on 40 percent of the settlement.

Counsel Comment #141: Take advantage of the after-tax consequences to offer less money in settlement to the employee. Whenever you are in the process of negotiating a payment or settlement, always attempt to put together a package that saves the company real dollars while creating a greater after-tax benefit for the employee receiving the settlement. Be as specific as possible when drafting settlement agreements and releases and write these with care. In addition to reducing the particular settlement allocation to writing, be sure to use specific lang- uage that complies with IRS Code language.

Be sure that all settlements are based on economic realities and good business practices, and that the parties will abide by them. In one case, the parties agreed on a certain allocation in the settlement agreement, yet the taxpayer claimed a different amount on his tax return. This triggered an IRS audit and both parties suffered substantial penalties and unnecessary expenses. To avoid this, you may wish to request in the settlement agreement a copy of the terminated employee's next tax return to be sure that the settlement allocation is followed per the agreement. Some lawyers also draft indemnification and hold harmless clauses protecting the company from individuals who fail to follow their promises in settlement agreements or releases.