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.

Will I Be Taxed on My Employment Law Settlement?

There’s nothing certain in life but death and taxes. So what made you think you wouldn’t be taxed on your employment law settlement? I ask people this all the time when they express absolute shock that taxes were withheld from their severance check and that they’ll get hit with a tax bill in April on their emotional distress damages.

            It’s not for lack of trying. Employment lawyers and advocacy groups on both sides of the aisle have been trying for years to get the Civil Rights Tax Relief Act passed, and 2011 was no exception. It was reintroduced in the Senate on November 2, 2011 to match the House version that was introduced in October.

            Right now, the law says that, if you are injured in a car accident or have another personal injury, your settlement or judgment isn’t taxable at all. However, if you’re the victim of discrimination and suffer emotional distress, you are taxed. You also can’t average the income, so you can be taxed at a very high rate. 

            Here are the types of recovery you might receive in your employment case, and how IRS looks at it.

            Back pay: You will be taxed. Payroll taxes must be withheld. You are taxed at a “supplemental wage rate.” It’s reported on a W-2. If the Civil Rights Tax Relief Act passes, multi-year back pay could be averaged over several years for tax purposes, lessening the tax hit.

            Front pay/future lost wages: You will be taxed. Payroll taxes must be withheld. You are taxed at a “supplemental wage rate.” It’s reported on a W-2. If the Civil Rights Tax Relief Act passes, multi-year front pay or future lost wage payments could be averaged over several years for tax purposes, lessening the tax hit.

            Severance: You will be taxed. Payroll taxes must be withheld. You are taxed at a “supplemental wage rate.” It’s reported on a W-2. If the Civil Rights Tax Relief Act passes, multi-year severance payments could be averaged over several years for tax purposes, lessening the tax hit.

            Emotional distress: Even if there are physical symptoms, you will be taxed. However, you don’t have payroll taxes withheld. The danger here is you’ll get hit with a big tax bill in April and, if you don’t put a big chunk of money aside to pay, you’ll be in trouble with the IRS. The employer has to report this payment to IRS, so you will definitely have to pay. It’s reported on a 1099-MISC. If the Civil Rights Tax Relief Act passes, emotional distress damages would no longer be taxable or reported as income to IRS. They would be treated similarly to physical injuries..

            Physical injuries: If you’re actually attacked, such as in a sexual harassment case with a rape, then money received for your physical injuries is not taxable income. However, if you mischaracterize emotional distress injuries as physical injuries, you could run into trouble in an audit. It is not reported to IRS.

            Liquidated damages: You will be taxed, but they are not wages. They will be reported to IRS on form 1099-MISC.

            Attorney’s fees: Attorney’s fees paid in your settlement are income to you, but are not wages. These will be reported as income to your attorney and you. However, under an earlier iteration of the Civil Rights Tax Relief Act where Congress only passed the portion addressing attorney’s fees, the fees are an above-the-line deduction for you in most employment law cases. In other words, you have to report them, but you won’t be taxed on them. This is something you need to discuss with whoever is preparing your tax return and make sure they understand it.

            Costs: Taxable but not wages. These are reported to IRS on 1099-MISC. You will be taxed on them, although they may be deductible.

            Interest: Taxable but not wages. This is reported to IRS on 1099-INT. Interest is taxable.

            Punitive damages: This is taxable but not wages. It will be reported on 1099-MISC.

            Overtime: Overtime payments will be taxed as wages. That means payroll taxes will be withheld and it will be reported to IRS on a W-2. If the Civil Rights Tax Relief Act passes, multi-year overtime payments could be averaged over several years for tax purposes, lessening the tax hit.

            Taxes: One solution that lawyers have negotiated in some large settlements involving back pay that represents years of income is to have the employer pay part of the employee’s tax hit that results from a lump sum payment. But the payment towards taxes is considered taxable wages. It will be reported on a W-2. This would no longer be necessary if the Civil Rights Tax Relief Act passes.

            Because the Civil Rights Tax Relief Act has been attempted and failed so many times, I’m not optimistic that it will pass anytime soon. Yet both employee-side organizations and business organizations support it. Both sides agree that it will make cases easier to settle, which means that litigation costs will go down. The courts will be less clogged. It will be good for just about everyone. 

            Maybe sometime before I retire this sensible bill will pass. If you think it’s a good idea, contact your Senator and Congressional representative and ask them to support the Civil Rights Tax Relief Act.