Settlements in the employment law context can set up thorny tax issues for employers. In this alert, we will discuss two key issues companies should consider when working toward a settlement agreement: the deductibility of settlement payments and tax reporting of settlement payments.

Deductibility of Settlement Payments 

The deductibility of an employer’s payment does not depend on whether the employer pays the amount in a settlement or following a judgment. If the amount paid is deductible, it will be so in either context.
 
Payments made following a judgment or pursuant to a settlement agreement may be deductible as trade or business expenses (under Internal Revenue Code §162) or possibly as production of income expenses (under §212).
 
In order to be deductible under either, the payment: (a) must not be personal in nature; and (b) must (i) constitute ordinary, necessary, and reasonable expenses, (ii) be paid or incurred during the tax year for which the deduction is sought, (iii) be directly connected or proximately result from the taxpayer’s business, income-producing activity, or investment activity, (iv) be currently deductible rather than a capital expenditure, and (v) be paid by the taxpayer that incurred it. While settlement payments in employment cases will generally be deductible, there are narrow exceptions, including when a payment is made to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry into a potential violation of any law (§162(f)). In these instances, the payment will not be deductible. 

In addition to the settlement amount paid to the plaintiff or claimant, an employer’s legal fees incurred in defending against a claim are deductible if the settlement payment made to the claimant is deductible as a trade or business expense (as explained above). 

Tax Reporting of Settlement Payments

An employer’s typical settlement agreement will need to distinguish between (a) taxable wages (which are reported on Form W-2 and subject to the associated withholding) and (b) taxable non-wage recoveries (which are reported on Form 1099 and are not subject to withholding). Due to implications for the employer regarding reporting and withholding requirements, the settlement amount should be allocated based on wage vs. non-wage recovery. The allocation should be incorporated into the settlement agreement itself. The allocation of the settlement payment receiving a “wages” designation typically includes severance, front and/or back pay, lost benefits, and any other payments typically made during the employment relationship. On the other hand, the allocation receiving a “non-wages” designation typically includes amounts made to settle potential tort claims, such as for emotional distress damages, and general releases for unspecified claims.  

Again, a settlement agreement should allocate the payments in accordance with the employer’s filing requirements, and the employer should retain the documents associated with the determination of those amounts. The allocation provision will provide an upfront agreement as to how the payment will be reported to the Internal Revenue Service (IRS)—and the applicable state agency—and can hopefully avoid any future issue or dispute with the IRS. 
 
In reviewing challenges to allocations in settlement agreements, courts have typically given deference to the parties’ express allocation of the various claims by settlement agreement, so long as they negotiated at arm's length and entered the agreement in an adversarial context. An employer may not have a preference as to the allocation of settlement payments, but maintaining arm’s length negotiations will help ensure the agreement receives deference.
 
To conclude, it is good practice for an employer to consider the potential claims and damages at issue and how each claim would be treated for tax purposes before finalizing a settlement agreement. There may be unique circumstances that affect the deductibility of the settlement payment and associated attorneys’ fees or the appropriate allocation of the wage vs. non-wage payments. Maintaining relevant documents, including the specific allocation in the agreement, and ensuring well-documented negotiations throughout the settlement process are best practices to avoid IRS-related disputes and obtain court deference.