Tax Treatment in Settlements and Severance Agreements

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It is well established that money paid out in settlement agreements, whether for severance or in settlement of claims against an employer involving injuries other than physical injuries, is income subject to taxation.  But, until relatively recently, it was unclear as to whether settlement money was subject to withholding or could be reported on an IRS 1099 form. United States v. Quality Stores, Inc. (U.S. Supreme Court, March 25, 2014) settled that.

Quality Stores was a Michigan-based agricultural-specialty retailer that declared bankruptcy in 2001.  Employees who were terminated received severance payments.  The Company at first treated the severance payments as wages, paid the employer’s share of FICA taxes, and withheld the employees’ shares of FICA taxes.  The Company then decided it should not have had to pay FICA taxes or withhold FICA taxes on behalf of employees, so it initiated a proceeding in the bankruptcy court on behalf of itself and the employees who received severance payments to recover the FICA payments the company made and the payments it withheld from employees’ severance checks.  The bankruptcy court found for the company and the employees, and the U.S. District Court affirmed, as did the U.S. Court of Appeals for the Sixth Circuit.  By a unanimous vote (8-0), the Supreme Court reversed and found for the IRS.

As a result, it is now clear that, unless the settlement involves compensation for physical injuries, federal and state taxes must be withheld on all settlement payouts.  And it must be remembered that the employer is primarily liable for a failure to withhold taxes when obligated to do so.  So if a settlement agreement provides for payments accompanied by a 1099 form, and the recipient of the payments does not pay taxes on the proceeds, the IRS can come after the employer for unpaid taxes, penalties, and interest.

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