First, the legal fine print. I am not a tax law professional or advisor. What follows is not meant as specific tax advice for you (even if you are a client of my firm). This post is meant to flag potential tax issues for you if you receive a severance payment. To know how this will affect you personally, I recommend that you see your friendly neighborhood tax lawyer or accountant.
So, here’s the deal. Unless you can work some serious tax voodoo, the tax man is coming for a piece of your severance payout. It is better to think about it now and prepare yourself. That way, you won’t be unpleasantly surprised when that long-awaited severance check finally hits your mailbox—for an amount a lot lower than what you expected.
How Taxes Affect Severances and Settlements
As I note above, while I can’t say what this will mean for YOU specifically, I can tell you generally how taxes work with employment law and wrongful termination cases.
Monies that employers pay as severance or settlement agreements involving discrimination, wage disputes, or wrongful termination cases fall into three primary buckets:
- lost wages (including back and front pay);
- emotional distress, punitive damages, or liquidated damages; and
- attorneys’ fees.
Attorneys often refer to the distribution of settlement amounts as “characterization.” For instance, the parties might agree on a total settlement amount of $60,000 in a discrimination case. From that amount, both sides might agree to characterize $20,000 as wages, $20,000 as payment for emotional distress, and $20,000 for attorneys’ fees.
Here’s how these separate payments are generally taxed.
Lost wages are taxed just like they would be if you were still employed by the company, even though you’re not. The important takeaway here is that you will probably be taxed at the same rate you were taxed at while you were employed, even if you are now in a lower tax bracket. Settlement fees that are taxed as wages include FICA withholding, social security, and other taxes.
Let’s say that, after you were fired, you have been unable to find a job, despite your best efforts. You had been working in upper management, paying about 30% of your check in total withholding. Since being fired, you’ve made so little money that you even qualified for the earned income tax credit. After a protracted battle with your company, you finally reached a substantial settlement. Some of that payment will be characterized as lost wages. Chances are very good that the amount paid out as lost wages will be taxed at your previous 30% tax rate, even though you are now dead broke. Why? This money is paid as if the wrong had not been done and you had never been fired. If you had never been fired, you would have been making the same salary and paying the same taxes.
Again, talk to your own tax advisor about this. When you do, you might want to ask about IRS Publication 15, particularly the section on supplemental wages. You can find that section here.
Emotional Distress, Punitive Damages, or Liquidated Damages
Damages that are characterized as emotional distress, punitive damages, or liquidated damages are sometimes taxed differently than lost wages. As a general rule, your employer will not withhold any taxes from these payments. So, if you receive $15,000 for emotional distress as part of your settlement, your employer will write you a check for $15,000. It will then issue an IRS Form 1099 noting that you have been paid this amount. Most people have to report this income to the IRS, where it will be taxed at their current applicable income tax rate.
If your settlement agreement includes settlement of claims under “fee-shifting” statutes, then your employer may agree to pay out some of the funds as payment for your attorneys’ fees. Fee-shifting statutes include most claims for discrimination, retaliation, wrongful termination, and wage claims. As with funds paid out for, say, emotional distress, this money will come straight to you, untaxed. The employer will issue a 1099 to you and your lawyer. In some instances, you can use attorneys’ fees paid to pursue an employment or civil rights case as an “above-the-line” deduction. That means they can reduce the taxable income that you report to the IRS, producing a clear tax benefit for you. But—say it with me now—you should talk to your own tax advisor about this possibility to see how it applies to your situation.
The Mechanics of the Settlement Process
Here’s the catch: an employer is not obligated under the law to pay out settlement fees in any particular way. The total amount of settlement and its characterization are always subject to negotiation. Generally, the experienced counsel representing an employer will be attuned to these issues and will be willing to structure the settlement to minimize taxes to you, the employee. Once everyone gets to the final number, the momentum on both sides favors getting the deal done. As a general rule, when the claims involved allow for the type of tax treatment discussed above, the company will agree to split the settlement into all three buckets, usually a third each—that is, one third as wages, one third for non-wage payment, and the final third for attorneys’ fees.
Here are some common issues that arise. You may want to discuss these with your own tax professional.
The Employee Wants Most of the Wages Characterized As Non-Wage Payments, Either as Compensatory Damages or Attorneys’ Fees
This is a reasonable tax-avoidance strategy that some employees suggest when settling a case. And, indeed, it is often in the employer’s interest to do this, because then it doesn’t have to pay its share of FICA taxes, as it does when it pays out settlement funds as wages.
The problem with this approach is that the IRS is well aware of this strategy and frowns upon it. Obviously, this reduces the amount of money paid to the government in taxes. If the IRS were to audit a company and find that a settlement agreement inappropriately characterized funds as non-wage payments, it could result in costly penalties for the company. The IRS could even penalize you, the former employee. For this reason, most employers require that at least a third of the settlement be characterized as payment for lost wages and thus subject to tax withholding. In rare circumstances, however, an employer will agree to pay out all funds as non-wage payments. If you face that option, consult with your tax advisor about the potential risk you face by accepting that payment.
The Employer Refuses to Characterize Payment as Anything Other Than Wages
On one occasion, we encountered an employer that was unwilling to characterize settlement payments as anything other than wages. In this instance, the employer was a large, national company that was under continual audit by the IRS. We were told that the IRS had an auditor based at the company full time. Because the IRS was already unhappy with how the company had handled settlement payments in the past, the company was now not allowed to settle employment claims as anything but wage payments, even when the claims brought allowed for compensatory damages and attorneys’ fees. It’s unlikely that this would happen to you. However, it’s something that you should clarify before agreeing to a settlement.
The Employer Withholds Too Much in Taxes
It is unfortunately not uncommon for the employer to screw up the amount of tax withholding in a settlement payment. For instance, we had one case where an employee was paid bimonthly. When it was time to write the settlement check, the payroll department calculated the taxes as if she were paid weekly—that is, as if she were paid twice what she had been getting paid. This meant that the employer withheld 50% too much in taxes. This kind of mistake can generally be fixed by having your attorney call the company and explain the mistake. It will, however, slow things down a bit, as the employer will have to reissue the check.
The Employer Is Late to Pay
This is fairly rare, but it does happen. Say that your settlement agreement provides that the employer must pay by the 15th. The 15th comes and goes, but nothing happens. What now?
Now you (or your attorney) calls the company counsel asking what happened to the payment. Most of the time, this is all it takes to get the check sent promptly. But we did, on one occasion, have company counsel take over a week to call us back—even though we reached out to him almost daily during that week.
Isn’t it a breach of the settlement agreement to fail to pay on time? Sure it is, but it rarely makes sense to file a breach of contract lawsuit because the employer is a day (or a week or even two weeks) late in getting the check delivered.
Why? There are a couple of reasons. The primary one is that it takes a long time to get a result by filing a lawsuit. It would probably take a week or more just for your attorney to draft the complaint and file it. Then the defendant company has 30 days to answer, and so on. By the time anything happens in the case, your former employer will probably have paid up. But what about breach-of-contract damages for failure to pay on time, you ask? They’re simply not worth it. Even assuming that you can win any, breach-of-contract claims do not allow for emotional distress or (usually) payment of attorneys’ fees. You are likely to win—at most—the few cents in interest that you could have earned on your money had the company paid you a few weeks earlier.
My advice is to play a mental game with yourself. Whatever your settlement agreement says to expect for time of payment, add two weeks and mark that date on your calendar. Don’t expect payment until then. If you get it earlier than that (and you probably will), you can be pleasantly surprised instead of being disappointed if the check is a day or two late.
The Employer Includes a Gnarly Indemnification Provision
It is not uncommon for an employer to include language in a severance agreement stating that you, the former employee, will cover the costs—including attorneys’ fees—for the company if the IRS audits the company and finds the severance was not appropriately characterized for tax purposes. If this came to pass, it could be incredibly expensive. You would be on the hook for any cost to the company. We’re talking thousands of dollars in interest and penalties, on top of the thousands of dollars in attorneys’ fees that you would be responsible for.
If this happens, you can try to negotiate with the company to remove this provision. It’s worth a try. But companies, for whatever reason, are often unwilling to let this go. Here’s the thing, though—I’ve never seen an employee actually have to pay the company because of an IRS audit. So, you’ve got to make your own decision after talking to your attorney. But if it were my decision—and if it were between agreeing to that provision or scuttling the settlement agreement altogether—I’d sign it with the provision and not worry about it a bit.
The Employer Wants to Pay Out Your Severance Payment Over Time
Put this in the category of good problems to have. But there can be occasions when a settlement payment—particularly if it is a large one—is structured so that it is paid out over time. This will reduce the taxes you pay since you are not receiving a lump sum. Yes, you should definitely talk to an accountant if you believe you are in this situation.
Summing It Up
- Know that the IRS is likely going to take a nibble—maybe even a chunk—out of your severance agreement.
- You have some ability to negotiate that tax treatment with your former employer.
- Talk to your attorney and an accountant before you sign the settlement agreement.
Need more help understanding whether you have an employment claim in the first place? Contact our office so we can discuss your situation and help you understand where you stand.