TAX IMPLICATIONS AND PRACTICAL IMPACTS OF DAMAGES IN by yurtgc548

VIEWS: 4 PAGES: 26

									TAX IMPLICATIONS AND PRACTICAL IMPACTS OF
      DAMAGES IN EMPLOYMENT CASES
  Brian Jorgensen | Jones Day | 2727 N. Harwood Street Dallas, Texas 75201 |
               (214) 969-3741 | bmjorgensen@jonesday.com
   Stephen Harris | Jones Day | 2727 N. Harwood Street Dallas, Texas 75201 |
                   (214) 969-5277 | sgharris@jonesday.com
Why Is This Important?
• Improper tax treatment can cause problems with
  IRS and taxing authorities.
• Can affect the direction of settlement discussions.
• Key issues:
   • Is the payment gross income?
   • Does the payment constitute wages?
   • Can the payor deduct the payment as trade or
     business expense or production of income
     expense?
   • Can the payment be capitalized?
         The “Origin of the Claim”
• The tax treatment of damages received in a
  settlement or award is inextricably tied to the claims
  giving rise to it and their merits. U.S. v. Gilmore, 372
  U.S. 39 (1963).
      – What is the dispute about?
      – Why is plaintiff receiving all this money?

• The complaint is the starting point and the
  underlying claims determine tax treatment.




                             3
        The “Origin of the Claim”
• Most settlement and award payments (unless
  excluded by IRC § 104(a)(2)) are treated as gross
  income to the recipient. The nature of that income
  is determined based on the nature of the underlying
  claims giving rise to the payments.
    Tax Treatment of Damage Components:
   Different Elements; Different Tax Regimes
• Backpay: Generally Treated as Wages
   • Subject to FICA and income tax withholding.
   • Reported on IRS Form W-2.
   • But see Newhouse v. McCormick (8th Cir 1998) –
     FICA and income tax withholding require an actual
     employment relationship.

• Front Pay: Generally Treated as Wages
   • Subject to FICA and income tax withholding.
   • Reported on IRS Form W-2.
   • But see Dotson v. US (5th Cir 1996) – only backpay
     portion of a settlement is wages.

                             5
  Tax Treatment of Damage Components:
 Different Elements; Different Tax Regimes
• Title VII, Texas Labor Code, etc.
   • Wages taxed as compensation for services.
   • Subject to FICA and income tax withholding.
   • Reported on IRS Form W-2.

• Age Discrimination (ADEA)/Fair Labor Standards Act
  (FLSA)
   • Wages taxed as compensation for services.
   • Liquidated damages: ordinary income but not wages.
      – Not subject to withholding.
      – Reported on IRS Form 1099.
  Tax Treatment of Damage Components:
 Different Elements; Different Tax Regimes
• Compensatory Damages
   • Not taxable if paid on account of physical injury
     or sickness.
   • Taxable if not paid on account of physical injury
     or sickness.
   • If taxable then reported on IRS Form 1099.

• Punitive and Liquidated Damages
   • Taxable regardless of underlying cause.
   • Reported on IRS Form 1099.
    Tax Treatment of Damage Components:
   Different Elements; Different Tax Regimes
• Torts: Personal Physical Injury
   • IRC § 104(a) excludes “the amount of damages
     (other than punitive damages) received . . . on
     account of personal physical injuries or physical
     sickness.”
      – Exclusion limited to physical injury and any
        emotional distress caused by physical injury
        (physical consequences not enough).
      – IRS’s position: must be “observable or
        documented bodily harm” (e.g., bruising, cuts,
        swelling or bleeding). CCM 2009-035


                              8
   Tax Treatment of Damage Components:
  Different Elements; Different Tax Regimes

• Emotional Distress, Harm To Business Reputation
   • Treated as ordinary income (generally not excluded
     from income).
   • Not subject to withholding; reported on IRS Form
     1099.
   • May be excluded to the extent claimant has incurred
     medical expenses for treatment of emotional
     distress.
   • But see Domeny v. Commissioner, T.C. Memo 2010-
     9.

                            9
Tax Treatment of Damage Components
• Recent Development: Severance Payments
  • IRS treats as wages under Regs. § 31.3401(a)-
    1(b)(4).
  • Michigan District Court holds to the contrary in
    U.S. v. Quality Stores, 1005 AFTR 2d 2010-1110
    (W.D. Mich. 2010) (calling severance non-taxable
    wage replacement social benefits).
  • But see CSX Corp. v. U.S., 518 F.3d 1328 (Fed.
    Cir. 2008).




                         10
   Hybrid Cases: Allocation Matters
• Allocating damages among multiple components of
  the settlement or award is crucial.
   • What does the complaint / record say?
   • What claims would a court find credible if the
     dispute were tried?
   • What types of damages does the applicable
     statute allow?
   • What is the relationship between the damage
     payment and the claimant’s regular
     compensation?


                           11
      The Allocation: Facts Matter
• Are the allocations reasonable?
   • What happened?
   • What do the facts, viewed disinterestedly,
     suggest?


• Emotional Distress Components
   • Is this a throwaway claim or a real concern?
   • What do the facts, viewed disinterestedly,
     suggest?


                          12
       Employer’s Responsibilities
• Withholding and paying over income and FICA tax,
  paying employer share of FICA tax, on all damages
  properly treated as wages.
      – Penalties for non-compliance.
• Correct reporting of wage and non-wage
  compensation on the appropriate IRS form.
      – Penalties for non-compliance.
• Do not rely on plaintiff indemnity (“We’ll handle the
  taxes and indemnify you.”)



                            13
      Other Notable Wages Issues
• Wages are treated as earned in year paid for
  FICA purposes, not when services provided.
   • U.S. v. Cleveland Indians Baseball Co.,
     532 U.S. 200 (2001).
• Circuits split on whether compensation in
  failure to hire cases is wages.
   • Newhouse v. McCormick & Co., 157 F.3d
     582 (8th Cir. 1998).
   • Melani v. Board, 814 F.2d 6563 (2nd Cir.
     1987)
                       14
                     Attorney’s Fees
• Attorney’s fees are:
   • Generally income to the plaintiff
      – Commissioner v. Banks, 543 U.S. 426 (2005)
   • Deducted “above the line” in discrimination cases
      – IRC §§ 62(a)(20), 62(e)
   • Not wages under current law (but see Rev. Rul. 80-364)
   • Generally reported twice
      – as income to the plaintiff (Regs. § 1.6041-1(f))
      – as income to the plaintiff’s attorney (Regs. § 1.6045-5)
   • Penalties for non-compliance
      – up to 20% of settlement under IRC §§ 6721, 6722



                                 15
Example (Proposed Language)
• A check made payable to Employee in the amount of ten
  thousand dollars ($10,000) for her wage claims (with
  respect to which, Employer will make the appropriate
  withholdings and will issue the appropriate W-2 form);
• A check made payable to Employee in the amount of two
  thousand dollars ($2,000 for her non-wage claims (with
  respect to which, Employer will issue the appropriate
  1099 form);
• A check made payable to Employee’s attorneys for
  attorney’s fees in the amount of three thousand dollars
  ($3,000) (with respect to which Employee will issue an
  IRS form 1099 form to Employee and Employee’s
  attorneys).
 Considerations In
Class Action Cases
    Attorneys’ Fees In A Class Action
                 Context
• Attorney’s fees are not income to the class
  members in an “opt-out” class action.
• Not so for “opt-in” actions in which claimants
  can all be identified.
  • Rev. Rul. 80-364.
  • Sinyard v. Commissioner, T.C. Memo 1998-364.
Expenses Deductible When “Economic
       Performance” Occurs
• Defense of business costs are generally
  deductible; exception for fines and penalties.
• Costs, however, are deductible only when
  amounts are actually paid to the claimant.
   • Regs. § 1.461-4(g)(2)
• Payment to a trust or fund generally does not
  constitute payment to the tort claimant.
• Delay in deductions lowers their value,
  increases after-tax cost of settlement.


                         19
 Use of “Qualified Settlement Fund” to
         Accelerate Deduction
• To address this concern, parties may use a
  Qualified Settlement Fund (“QSF”).
• Requirements for a QSF:
   • Settlement approved by and implemented
     under continuing jurisdiction of court or other
     governmental authority.
   • Payment resolves or satisfies qualifying
     claims.
   • Payment is made to a trust or funds are
     otherwise segregated from defendant’s other
     assets.

                          20
             “Resolve or Satisfy”
• QSFs may be used to resolve
  • Claims arising out of tort, breach of contract, or
    violation of law
  • CERCLA claims
• QSFs cannot be used to resolve
  • Workers’ compensation claims
  • Self-insurance claims
  • Warranty claims
  • General creditor claims



                            21
      Benefits of QSFs to Defendants

• Immediate deduction on payment of funds to the
  trust even though plaintiffs may not receive the
  money for years.
• Release of liability from the court.
• No information reporting or tax withholding
  responsibilities since payment is not being made to
  plaintiff.
        Benefits of QSFs to Plaintiffs
• Delay recognizing income until distribution is made
  from the QSF.
• Freedom to arrange affairs without the involvement
  of defendant.
      – Plaintiffs are able to negotiate tax language
        and reporting requirements in a separate
        agreement with the QSF, and not defendant.
• Time to work out details of distributions, structure
  attorney’s fees, etc.
        Procedural Aspects of QSFs
• Require an “administrator.”
   • Regs. § 1.468B-2(k)(3).
• Taxed on investment income at trust rates.
   • Regs. § 1.468B-2(a).
• File own tax returns and provide claimants with any
  required information return (e.g., 1099s).
   • Regs. §§ 1.468B-2(k)(1), -2(l)(2).




                           24
         Concluding Thoughts


• Tax matters when negotiating settlements.

• Tax results can be strange.




                       25
                   Questions?
                   Brian Jorgensen
                   Jones Day
                   2727 N. Harwood Street
                   Dallas, Texas 75201
                   (214) 969-3741
                   bmjorgensen@jonesday.com


                   Stephen Harris
                   Jones Day
                   2727 N. Harwood Street
                   Dallas, Texas 75201
                   (214) 969-5277
                   sgharris@jonesday.com




DLI-6350361 v. 1           26

								
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