Anytime there is a judgment, award of damages, or settlement that involves the transfer of funds a careful analysis should be undertaken to determine the appropriate taxability and reporting related to the transfer. Typically, during settlement negotiations, both parties will willingly attempt to allocate and classify a portion of the settlement proceeds as a class of payment that would not be subject to income or employment taxes. For example, compensatory damages paid on account of one’s personal injuries are not included in income, but payments for emotional distress would be included in income. In addition, payment of back wages or dismissal/severance payments would generally be considered not only income, but subject to payroll taxes; whereas, amounts allocated penalties or liquidated damages would be income but not subject to payroll taxes.
As a result of a recent Supreme Court decision (Quality Stores, Inc.) which defined “wages” in a very broad sense and which held that severance payments were wages for FICA purposes, there was some fear that penalties or liquidated damage payments stemming from employment cases would also be classified as wages and subject to payroll taxes.
Fortunately, the IRS has held that, at least with respect to “waiting time penalties” under Section 203 of the California Labor Code these penalty payments are different from severance payments because it is based on an employer’s failure to timely pay final wages. (See ILM 201522004.) The employee had no right to payment of the late penalty based on the employee’s service. Instead, the penalty is akin to liquidated damages and would not be classified as wages for employment tax purposes. While this decision by the IRS was directed to Section 203, California and Federal law is filled with many other employment related penalties that kick in when employers commit “technical” violations with respect to their employers. Thus, this ruling should offer comfort to tax and employment attorneys who attempt to classify or allocate large settlement proceeds in employment or wage and hour cases.