Read the IRS Chief Counsel advice memo [PDF 114 KB]
The taxpayer (an employer) entered into multiple settlement agreements with former employees, with the agreements providing that the employees waived claims under a variety of statutes in return for specified sums. The settlement agreements resolved a variety of claims brought by employees (e.g., age discrimination, disability, and civil rights claims).
The taxpayer paid out a variety of payments in settling claims, including wages, tort damages, reimbursements of medical costs, and attorney’s fees. The amounts of attorney’s fees were in some instances paid directly to the employee, in other instances paid to the employee’s attorney, and still in other instances paid to both the employee and the attorney.
During an IRS examination, it was discovered that certain settlement payments were mistakenly reported to the employees on Forms 1099-MISC rather than on Forms W-2 and, thus, employment taxes were underwithheld. The taxpayer agreed to correct those errors.
Chief Counsel advice
The IRS Chief Counsel advice memo concludes that—absent a specific allocation for attorney’s fees in the settlement agreements—amounts of attorney’s fees paid by an employer as part of a settlement agreement with a former employee are includable in income and are subject to employment taxes to the extent they are wages attributable to an employment-related claim.
The IRS’s position is that payments constituting severance payments, back pay, and front pay are wages for employment tax purposes; yet, the IRS memo observes that there is disagreement among federal courts of appeals on the character of severance pay, back pay, and front pay.
The IRS memo further notes that appropriate information reporting requirements depend on the facts and circumstances of each case, and that 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 must be filed and furnished to the employee on Form W-2, Wage and Tax Statement.
If the attorney’s fees are specifically allocated, they generally must be filed and furnished to the employee on Form 1099-MISC, Miscellaneous Income. The reportable amounts are always to be filed and furnished to the attorney on Form 1099-MISC.
The memo concludes that 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 sections 6721(a) and 6722(a), and if the employer intentionally disregarded the reporting requirements, the penalties increase under sections 6721(e) and 6722(e).