Why Did The Lawyer Put This In My Settlement Agreement?: Tax Indemnification

This will continue my series of posts about deconstructing the legalese in employment contracts. This week I'll discuss some language I frequently see in severance or settlement agreements when at least some of the money being paid isn't having taxes withheld. The clause will look something like this:

Employer makes no representation as to the taxability of the amounts paid to Employee. Employee agrees to pay federal or state taxes, if any, which are required by law to be paid by Employee with respect to this settlement. Moreover, Employee agrees to indemnify Employer and hold it harmless from any interest, taxes or penalties assessed against it by any governmental agency as a result of Employee's non-payment of taxes on any amounts paid to Employee or Employee's attorney under the terms of this Agreement.

The reason the employer wants this language is that most employment law settlements are for back wages, future lost wages, or severance, which are wages. Wages must have taxes withheld and the employer has to pay its share of employment taxes on them. If the IRS should come back later and claim more (or all) of it should have been wages, the employer wants the employee to agree they'll pay both the employee's and the employer's share of employment taxes on this.

I'm unusual in the way I request settlement money be paid to clients. I usually ask that the employee's portion be paid as wages. I have a couple reasons for this. First of all, no matter how many times I tell the employee to set aside about 1/3 of the money in a CD that comes due on April 1 so they can pay their taxes, it's too tempting to spend the money. I've had too many people call me crying in April that they can't pay their taxes. Second, if IRS should determine that the money should have been wages, my clients can't afford to pay their employer's share of taxes on top of theirs. It's a risk that I usually don't recommend.

Now, let's go back to this tax clause. I used to not object to it being added as is. If my client asks that some of the money be set aside as something other than wages, they should be willing to take the risk that they got it wrong. (On the other hand, if the employer insists that some portion of it be designated compensatory damages or emotional distress damages so they can save money, I insist they take this language out). I say I used to agree because I actually had one employer, after the fact, argue that this clause meant they could withhold the employee's federal income tax and employment taxes, then not pay them in, plus they said they didn't have to pay in their share of employment taxes on the wages amount.

It's probably an only-in-South-Florida thing, but still, this kind of jerkish behavior means I have to change the language in the future. Here's what I now ask employers to add to this clause:

This provision shall not apply to Employer's obligation to pay in amounts withheld and its share of employment taxes on the amount paid pursuant to paragraph ___.

The blank, of course, is filled with the subparagraph that sets out the amount being paid to the employee as wages.

When the attorney's fees are being paid, I insist they be paid separately because they aren't wages. Under the Civil Rights Tax Fairness Act, which used to be part of the mostly-rejected Civil Rights Tax Relief Act, they are still income to both the client and my firm. However, the client should be able to take an above-the-line deduction on their tax return (whatever the heck that is - ask your accountant) so it comes out as a wash.

Basically, there's no way to structure an employment law settlement so any portion of it isn't taxable, at least that I've ever heard of. There have been efforts to pass the Civil Rights Tax Relief Act for decades, all of which have failed. This law would make emotional distress damages tax-free. If you think it's wrong to tax emotional distress damages, which makes it harder to settle employment cases for both employers and employees, talk to your member of Congress.

In the meantime, expect to see these tax indemnification clauses in your agreements, and beware unscrupulous employers who try to use them to force you to pay their share of taxes.