Category Archives: Tax Law

Tax

This is a Non Profit Project. We don't collect personal data and we don't use cookies.

Tax in California

External Online Resources

For California Attorneys: Tax

There is more information about this subjet in the California legal portal in these entries: Fee Payments Charitable Exemption Settling Cases

Tax Appeal Systems in California: General Overview

This section provides a summary of the framework of tax appeal systems in the area of taxation in California.

California Tax Appeal Systems

Legal Forms

This is a Non Profit Project. We don't collect personal data and we don't use cookies.

Legal Forms in California

Research Guide – California Legal Forms

California Civil Procedure Formbooks

These include:

  • California Affirmative Defenses 2d, Bancroft Whitney, 5 volumes. These forms are for defenses to civil actions. This publication is also available on Westlaw (Formerly, CAAFDEF).
  • California Civil Litigation Forms Manual, Continuing Education of the Bar, 2 volumes. The forms in this practice guide are derived from CEB civil procedure and civil discovery books. Sample forms are including.
  • California Civil Procedure Before Trial, 3rd ed., Continuing Education of the Bar, 3 volumes. This publication is also available on Lexis (formerly, ceb;cebcpt).
  • California Forms of Pleading and Practice, Annotated, Matthew Bender, 55 volumes. This is a very comprehensive and current set of California legal forms. It includes relevant laws and the procedures for using the forms. It is organized by subject. These forms are available on Lexis.
  • California Practice Guide: Alternative Dispute Resolution, Rutter Group. This publication is also available on Westlaw (Formerly, TRG-CAADR).
  • California Practice Guide: Civil Appeals and Writs, Rutter Group, 2 volumes. This publication is also available on Westlaw (Formerly, TRG-CACIVAPP).
  • California Practice Guide: Civil Procedure Before Trial, Rutter Group, 3 volumes. This publication is also available on Westlaw (Formerly, TRG-CACIVP).
  • California Practice Guide: Civil Trials and Evidence, Rutter Group, 3 volumes. This publication is also available on Westlaw (Formerly, TRG-CACIVEV).
  • California Practice Guide: Enforcing Judgments and Debts, Rutter Group, 2 volumes. This publication is also available on Westlaw (Formerly, TRG-CADEBT).
  • Debt Collection Practice in California, Continuing Education of the Bar, 2 volumes.
  • Practicing California Judicial Arbitration, Continuing Education of the Bar.

Judicial Council Forms

These include:

  • California Forms of Pleading and Practice, Annotated, Matthew Bender. A three volume supplement, Judicial Council Forms, contains forms for use in discovery, wage garnishment, family law, juvenile court law, guardianship, civil harassment, and small claims proceedings.
    These forms are available on Lexis.
  • California Judicial Council Forms Manual, Continuing Education of the Bar, 4 volumes. Forms can be removed for copying and are accepted by the California courts. Set includes table of contents, alphabetical list of forms, and table of statutes and rules.
  • West’s California Judicial Council Forms, 4 volumes. For use in conjunction with West’s Annotated California Codes. Forms are effective through current year.

Judicial Council Forms are also available through the California Courts’ Internet homepage.

Jury Instructions and Selection

  • [CACI] California Jury Instructions: Civil, Plain English, This publication is also available on Westlaw (Formerly, CA-CACI) and Lexis (Formerly, cal;cjcjur).
  • [BAJI] California Jury Instructions: Civil, 9th ed., 2 volumes. This publication is also available on Westlaw and Lexis.
  • Bennett’s Guide to Jury Selection and Trial Dynamics:California Civil Litigation, West Publishing Company. Forms for jury selection, including sample questionnaires for different types of trials. These forms are also available on Westlaw (formerly, through the LTG-TP database). Hint: To limit your search to Bennett’s, add “ci (bennett)” to your search.
  • [CALCRIM] California Jury Instructions: Criminal, Plain English, 2 volumes. This publication is also available on Westlaw and Lexis.
  • [CALJIC] California Jury Instructions: Criminal, 6th ed., 2 volumes. This publication is also available on Westlaw and Lexis.
  • Bennett’s Guide to Jury Selection and Trial Dynamics:California Criminal Litigation, West Publishing Company. Forms for jury selection, including sample questionnaires for different types of trials. These forms are also available on Westlaw (formerly, through the LTG-TP database). Hint: To limit your search to Bennett’s, add “CI (bennett)” to your search.
  • California Forms of Jury Instructions, Matthew Bender, 4 volumes. These forms are also available on Lexis.
  • California’s New Civil Jury Instructions are available through the California Courts’ web page at http://www.courtinfo.ca.gov/reference/documents/civiljuryinst.pdf. There is a conversion chart at the end for cross-referencing BAJI numbers with the correct numbers for the new instructions.
  • FORECITE: Latest Developments in California Criminal Jury Instructions. This looseleaf volume supplements and updates CALJIC.

Formbooks Organized by Subject Specialization

Multi-Subject Formbook Sets:

  • California Legal Forms: Transaction Guide, Matthew Bender, 36 volumes. Includes forms for business and nonprofit organizations, real estate transactions, commercial transactions, wills & trusts, contracts & obligations, performance of services, and personal transactions.
    These forms are also available on Lexis.
  • West’s California Code Forms With Practice Commentaries, 46 volumes. For use with West’s Annotated California Codes. Includes volumes devoted to Business and Professions, Civil, Civil Procedure, Commercial, Corporations, Education, Elections, Fish & Game, Food & Agricultural, Insurance, Government, Labor, Probate, Public Utilities, and Revenue & Taxation. This publication is also available on Westlaw.

Attorney’s Fees:

  • California Attorney Fee Awards, 2nd ed., Continuing Education of the Bar. This guide includes forms for recovering attorney’s fees.
  • Fee Agreement Forms Manual, Continuing Education of the Bar. This guide provides a complete and practical guide to planning and drafting attorney-client fee agreements that meet the requirements of the fee agreements statute.

Businesses and Business Entities:

  • Advising California Employers and Employees, 2nd ed., Continuing Education of the Bar, 3 volumes. These forms are available on Lexis.
  • Advising California Partnerships, Continuing Education of the Bar. These forms are also available on Lexis.
  • California Practice Guide: Corporations, The Rutter Group, 2 volumes. These forms are also available on Westlaw.
  • California Corporation Laws, Ballantine & Sterling, 7 volumes. These forms are also available on Lexis.
  • California Transactions Forms : Business Entities, Bancroft-Whitney, 6 volumes. These forms are also available on Westlaw.
  • California Transactions Forms: Business Transactions, Bancroft-Whitney, 6 volumes. These forms are also available on Westlaw.
  • Financing and Protecting California Businesses, Continuing Education of the Bar. Forms for business startups.
  • Drafting Business Contracts: Principles, Techniques & Forms, Continuing Education of the Bar. These forms are also available on Lexis.
  • Forming & Operating California Limited Liability Companies, Continuing Education of the Bar. These forms are also available on Lexis.
  • Selecting & Forming Business Entities, Continuing Education of the Bar, 3 volumes. These forms are also available on Lexis.

Class Actions:

  • Cohelan on California Class Actions, West Group. This publication has forms and samples for filing class actions.

Criminal Law:

  • California Criminal Practice, Motions, Jury Instructions and Sentencing, 3rd ed., Thomson-West, 5 volumes.
  • California Criminal Law Forms Manual, Continuing Education of the Bar.

Family Law:

  • California Family Law: Practice and Procedure, Matthew Bender, 6 volumes. These forms are also available on Lexis. Includes a supplement with Judicial Council Forms.
  • California Family Law Trial Guide, Matthew Bender, 4 volumes. This publication is also available on Lexis.
  • California Marital Settlement and Other Family Law Agreements, 3rd ed., California Continuing Education of the Bar.
  • California Practice Guide: Family Law, Rutter Group, 3 volumes. This publication is also available on Westlaw.
  • California Transaction Forms: Family Law, West Group, 2 volumes. Also available on Westlaw.

Insurance Law:

California Practice Guide: Insurance Litigation, The Rutter Group, 3 volumes.
These forms are also available on Westlaw.

Landlord-Tenant Law:

  • California Eviction Defense Manual, Continuing Education of the Bar, 2 volumes. This publication is also available on Lexis.
  • California Landlord-Tenant Practice, Continuing Education of the Bar, 2 volumes. This publication is also available on Lexis.
  • California Practice Guide: Landlord-Tenant, Rutter Group, 2 volumes. This publication is also available on Westlaw.
  • California Tenants: A Guide to Residential Tenants’ and Landlords’ Rights and Responsibilities, State of California. Available online at http://www.dca.ca.gov/legal/landlordbook/index.html. Published by the California Department of Consumer Affairs.
  • California Tenants’ Rights, Nolo Press.
  • The California Landlord’s Law Book: Rights and Responsibilities, Nolo Press.

Real Property, Financing, and Construction Law:

  • California Practice Guide: Real Property Transactions, Rutter Group, 2 volumes. This publication is also available on Westlaw.
  • California Real Estate Forms,2nd ed., [Miller and Starr] Bancroft-Whitney, 4 volumes. These forms accompany Miller and Starr, California Real Estate 2d, the preeminent treatise on real estate law in California. Volume 1 contains forms pertaining to the purchase and sale of real property; Volume 2 contains forms pertaining to leasing transactions. Also available on Westlaw.
  • California Real Property Practice Forms Manual, Continuing Education of the Bar. This practice guide collects forms from CEB’s most commonly used real property books in one easy-to-use volume. Readers can remove forms for easy photocopying.
  • California Construction Contracts and Disputes, Continuing Education of the Bar. This practice guide has forms for drafting California construction contracts. This publication is also available on Lexis.
  • California Lis Pendens Practice, 2nd ed., Continuing Education of the Bar. This practice guide has forms for filing and perfecting notices of pending actions.
  • California Mechanics Liens and Related Construction Remedies, 3rd ed., Continuing Education of the Bar. This practice guide has forms for statutory remedies on public and private construction projects. This publication is also available on Lexis.
  • Condemnation Practice in California, 3rd ed., Continuing Education of the Bar, 2 volumes. Litigation forms are available in this publication.
  • Financing and Protecting California Businesses, Continuing Education of the Bar, 2 volumes.
  • Forming California Common Interest Developments, Continuing Education of the Bar, 2 volumes. This publication has forms for creating a common interest development.
  • Ground Lease Practice, Continuing Education of the Bar. This practice guide has forms for drafting building leases.
  • Office Leasing: Drafting and Negotiating the Lease, Continuing Education of the Bar, 2 volumes. The practice guide has forms for drafting commercial leases. This publication is also available on Lexis.
  • Real Property Exchanges, Continuing Education of the Bar.

Taxation:

  • Print: For tax forms, looseleaf services with forms are pageable. Also, state tax formbooks for the current year are in the Reference Collection.
  • Internet: California tax forms are available on the Internet at: http://www.ftb.ca.gov/forms/index.html and federal tax forms are available at: http://www.irs.ustreas.gov/formspubs/index.html

Tort Law:

  • California Practice Guide: Personal Injury, Rutter Group, 2 volumes. Also available on Westlaw.
  • California Products Liability Actions, Matthew Bender. Also available on Lexis.

Wills & Trusts and Elder Law:

  • California Elder Law: An Advocate’s Guide, Continuing Education of the Bar, 2 volumes. Also available on Lexis.
  • California Practice Guide: Probate, Rutter Group, 2 volumes. This publication is also available on Westlaw.
  • California Transaction Forms: Estate Planning, 2nd ed., West Group, 4 volumes. This publication is also available on Westlaw.
  • California Will Drafting, Continuing Education of the Bar, 3 volumes. Also available on Lexis.
  • Drafting California Revocable Trusts, Continuing Education of the Bar. This publication is also available on Lexis.
  • Drafting California Irrevocable Trusts, California Continuing Education of the Bar, 2 volumes. This publication is also available on Lexis.
  • California Conservatorship Practice,Continuing Education of the Bar, 2 volumes.
  • This publication is also available on Lexis.

California Forms on the Internet

  • FindLaw California: Legal Forms
  • Judicial Council Legal Forms
  • California Business Portal: http://www.ss.ca.gov/business/corp/corp_formsfees.htm
  • Internet Legal Resource Guide: Legal Forms Archive – http://www.ilrg.com/forms
  • LexisONE provided access to more than 6,000 forms, as well as forms from the extensive Matthew Bender collection. While the forms are free to view, there is a charge to use the interactive forms, and users must register and select a password.
  • The California Superior Court hosts EZLegalFile at http://www.ezlegalfile.org, where interactive forms for family, marriage, divorce, small claims, evictions, guardianship, and domestic violence can be filled out online and printed in a form suitable for filing.

California Forms on Lexis and Westlaw

  • LEXIS: There are many California legal forms on Lexis in the Matthew Bender Treatises and the CEB publications.
  • WESTLAW: There are numerous California legal forms available on Westlaw. To locate the list of forms, go to the online Westlaw directory, select “State Materials”, then select “California”, and then select “Forms, Treatises, CLEs and Other Practice Material”.

Workplace Settlements

This is a Non Profit Project. We don't collect personal data and we don't use cookies.

Workplace Settlements in California

Tax liabilities in Settlements of Workplace Litigation

By Alan S. Levins and Jason E. Shapiro. The first is a shareholder and the second is an associate at Littler Mendelson in San Francisco. They represent employers in employment litigation.

Although most cases are resolved by settlement, not every lawyer appreciates the tax ramifications of settlement payments, particularly in the context of employment litigation. Payments made pursuant to an employment-related settlement fall into the following categories:

•wages or salary, subject to W-2 reporting;

•neither wages nor salary, but income that must be reported to taxing authorities;

•payment that is not income but must be reported; and

•payment that is not income and need not be reported.

When a case is resolved, it is crucial for employers, employees, and counsel to understand the tax implications. They should know which portions of a settlement are subject to taxation and the proper procedures for complying with both the Internal Revenue Code (tax code) and the Regulations of the Internal Revenue Service (Treas. Regs.). Employers settling employment-related claims may have to pay payroll taxes, take proper withholdings, file information returns for 1099 income—or none of the above, depending on the circumstances. The improper characterization of a payment could result in an unwanted tax controversy with the IRS, not to mention substantial monetary consequences. The best approach is to know the rules and plan accordingly, so both sides can negotiate a fair settlement that will truly end the dispute.

Is It Taxable?

To begin with, it is important for employers to distinguish between taxable and nontaxable settlement payments. That’s because employers that misclassify settlement payments as 1099 income instead of W-2 income can be liable for the unpaid tax burden of the settlement proceeds, interest, and penalties (26 U.S.C. § 3509; see also Treas. Reg. § 31.3403-1) (26 U.S.C. §§ 3509, 6651(a)(2) and (3), and 6656(a)).

The general rule for employers is that all payments to employees are taxable, unless the income is exempted by a specific section of the tax code. (26 U.S.C. § 61.) Whether payments are subject to taxation as wages or salary (requiring withholding and payment of payroll taxes), or as 1099 income (no withholding) depends on the reason for the payment and, in some cases, how it’s characterized in settlement documentation. (See Parkinson v. Comm’r, 2010 WL 2595005 (Tax Ct. Mem. Decis.).)

The central question in determining whether a payment is taxable is: In lieu of what was the settlement amount paid? (Bagley v. Comm’r, 105 T.C. 396, 406 (1995), aff’d, 121 F.3d 393 (8th Cir. 1997).) Accordingly, allotting portions of the settlement payment to specific damages alleged by the former employee will help employers determine which portions of the settlement payment are taxable.

Here we review several of the more common items, along with their tax implications.

Lost Compensation

When employees seek damages from their former employer, they usually do so via a variety of claims, such as breach of contract, unpaid overtime, and alleged work “off the clock.” (Cal. Lab. Code §§ 510 and 512.) Lost compensation claims may seek back pay for wages the employee did not receive for work performed; they may also involve work that should have been performed, in which case the monetary recovery is referred to as “front pay” for wages that would have been earned but for the employer’s allegedly unlawful action.

Settlement payments for lost compensation are generally taxable to the employee and deductible to the employer. Withholdings and the payment of payroll taxes are required when settlement payments are made for lost compensation.

Interest Income

When settlement dollars compensate an employee for lost interest, the payment is treated as taxable income to the recipient. However, interest payments are not subject to payroll taxes or withholding. (Greer v. Comm’r, 2000 WL 37725 (Tax Ct. Mem. Decis.).) Interest income must be documented in a Form 1099. (26 U.S.C. § 6041; Treas. Reg. § 1.6041-1(b).)

Physical Injury

The tax code expressly excludes from gross income those payments intended to compensate litigants for “injuries” or “sickness.” (26 U.S.C. § 104(a)(2).) Congress amended section 104 in 1996 via the Small Business Job Protection Act (Pub. L. No. 104-188), adding the word physical to qualify the words injuries and sickness. Thus, settlement payments for damages relating to alleged physical injury or physical sickness are not taxable. (See H.R. Rep. No. 104-737, at 301 (1996) (Conf. Rep.) (providing an example that damages received for a loss-of-consortium claim due to the physical injury or physical sickness of a spouse are excludable from gross income).)

In addition, settlement payments received on account of personal physical injury or physical sickness are not reportable as 1099 income. (The IRS offers a helpful publication: “Lawsuits, Awards, and Settlements Audit Techniques Guide.”) Although section 104(a)(2) of the code does not define “physical injury” or “physical sickness,” the IRS has provided some guidance, noting that “physical injury” requires either observable or documented bodily harm, such as bruises, cuts, swelling, or bleeding. (See IRS Ofc. of Chief Counsel Mem. 2009-035 (Oct. 22, 2008).) The IRS has also said that a settlement payment made to compensate for alleged loss of consortium, survival, and wrongful death would not be taxable because the claims arose from the physical sickness of the claimant’s husband: cancer, caused by asbestos fiber inhalation. (See I.R.S. Priv. Ltr. Rul. 200121031, 2001 WL 564931 (Feb. 26, 2001).)

Emotional Distress

Section 104(a)(2) specifically provides that emotional distress is not to be treated as a physical injury or physical sickness. Because no statutory exemption is available, settlement payments that compensate for emotional distress are generally taxable—even when physical symptoms occur as a result of the emotional distress. (See Shelton v. Comm’r, 2009 WL 1456477 (Tax. Ct. Mem. Decis.).) The legislative history of the Small Business Job Protection Act of 1996, and tax court cases, note that the symptoms of emotional distress can include but are not limited to insomnia, headaches, stomach disorders, depression, skin irritation, appetite loss, asthma, and sleep deprivation. (See H.R. Rep. No. 104-737, at 301 n. 56 (1996) (Conf. Rep.), 1996-3 C.B. 741, 1041; see also Lindsey v. Comm’r, 2013 WL 1052772 (Tax. Ct. Mem. Decis.).)

Tax courts have recognized two separate exceptions to this rule. Payments for emotional distress will not be taxable:
•if the damages are caused by a physical injury or physical sickness; and
•to the extent the damages do not exceed payments made for medical care attributable to emotional distress.(Moulton v. Comm’r, 2009 WL 416010 (Tax. Ct. Memo. Decis.); see also Smith v. Comm’r, 2014 WL 4652904 (Tax. Ct. Summ. Op.).)

Therefore, if the individual’s claims of emotional distress are attributable to a physical injury or physical sickness, the settlement payment can be treated as compensation for physical injuries or physical sickness—and the payment will be exempt from taxation under section 104(a)(2) and need not be reported. (See Conf. Rep. at 301 n. 56; IRS Publication 4345 (Rev. Nov. 2011).)

With regard to the second exception, “the exclusion from gross income specifically applies to the amount of damages received that is not in excess of the amount paid for medical care attributable to emotional distress.” (See Moulton, 2009 WL 416010 at *4.)

If neither of these two exceptions applies, any emotional distress payment is income and must be reported in a Form 1099.

Punitive Damages

Punitive damages are generally taxed as part of gross income, but they are not subject to payroll taxes. Even when awarded in connection with settlement payments for physical injuries and physical sickness, punitive damages are not excluded from gross income. (See Greenberg v. Comm’r, 2011 WL 240101 (Tax. Ct. Memo. Decis.).) This rule is set forth specifically in the code; the section 104(a)(2) exclusion is for payments “other than punitive damages.” Punitive damages received in a settlement payment are reportable as 1099 income.

Although generally not applicable in the employment context, an exception to this general rule is a wrongful death case. (See 26 U.S.C. § 104(c)(1).)

Attorneys Fees

All parties should be aware that the payment of attorneys fees is generally taxable to the litigant, regardless of the type of fee arrangement—whether hourly, flat, or contingent. This rule applies even if the fees are not paid directly to the litigant. (See Treas. Reg. § 1.6041-1(f); Comm’r v. Banks, 543 U.S. 426, 430 (2005).) Attorneys fees are taxable to the claimant and reportable as 1099 income, but they are not wages and are not subject to tax withholding. (See Rev. Rul. 80-364 (1980).)

Liquidated Damages

Liquidated damages included in a settlement agreement do not constitute wages for federal employment tax purposes, even if they are owed for a violation of the Fair Labor Standards Act of 1938. (See Rev. Rul. 72-268 (1972).) Accordingly, though employers are not required to take tax withholdings from portions of the settlement payment that provide for liquidated damages, those portions of the payment are still reportable as 1099 income to the claimant.

Reporting, Withholding, and Payroll Taxes

As noted, employers are required to report settlement payments to the IRS depending on the characterization of, and intent behind, the settlement proceeds. Payments that compensate a litigant for wage-related losses must be reported in a Form W-2, just as if they were paid by the employer for regular hours worked. (See 26 U.S.C. § 6051; Treas. Reg. § 31.6051-2(a).) Employers will accordingly deduct applicable taxes and withholdings (for Social Security, Medicare, and the like), and must pay the matching taxes to the IRS. (See 26 U.S.C. § 3402(a).) The Supreme Court has ruled that payroll taxes relating to a back-pay settlement are based on the year that the employees received the money, not the year in which the wages should have been paid. (See United States v. Cleveland Indians Baseball Co., 532 U.S. 200, 219 (2001).)

If a settlement payment constitutes taxable income but is not allocated to lost wages—such as a payment for physical injuries, punitive damages, liquidated damages, and interest—it needs to be reported in a Form 1099. (See 26 U.S.C. § 6041; Treas. Reg. § 1.6041-1(b).)

But if the payment is not taxable at all, the employer doesn’t have any reporting, withholding, or payroll tax obligations.

Best Practices

Often employers agree to pay a single lump sum to settle multiple types of damages. If only a portion of the settlement payment is taxable, how is the employer to determine the extent of its reporting, payroll tax, and withholding obligations? Here are several steps to take.

First, employers should make sure that the settlement agreement expressly states the allocation of the payment(s). This practice is strongly encouraged because a settlement agreement entered into between adversarial parties in good faith and at arm’s length—which expressly allocates the settlement proceeds among multiple types of claims or damages—is generally binding for tax purposes. (See Bagley v. Comm’r, 105 T.C. 396, 406 (1995), aff’d, 121 F.3d 393 (8th Cir. 1997).)

The parties may also choose to submit the settlement agreement to a court to confirm that the allocation of damage amounts is reasonable. Court approval of the settlement agreement decreases the likelihood of a challenge to the allocation of the settlement payment because it lessens the appearance that the litigant and employer colluded to gain the most favorable tax status. Such challenges are more likely to arise when very little of the settlement payment is allocated to wages. Accordingly, a court’s approval will assist the parties in negating any adverse inference by the IRS. If the parties do not specify the allocation of a lump sum settlement payment, the IRS will determine the allocation by reference to the underlying nature of the claims alleged and to the evidence of the payor’s intent in settling those claims. The tax courts will determine the payor’s intent by reviewing “all the facts and circumstances of the case, including the complaint that was filed and the details surrounding the litigation.” (Domeny v. Comm’r, 2010 WL 114287 (Tax Ct. Memo. Decis.).) Though the IRS is less likely to accept an after-the-fact allocation made by the parties, it may be sustained if there is contemporaneous, extrinsic evidence (such as attorney notes, settlement offers and counteroffers, or interrogatory responses) to support it.

Employers may further protect themselves from incurring additional tax liabilities, financial penalties, and interest payments by including an indemnity clause in the event the settlement allocation is challenged. The clause should note that the litigant will be responsible for any taxes, penalties, or interest assessed against either the litigant or the employer as a result of the settlement, and that the claimant agrees to indemnify, defend, and hold harmless the employer for any such taxes, penalties, or interest resulting from the settlement agreement.

Note, however, that a promise of indemnification is only as good as the assets of the indemnifier. The employer may still be held liable for any penalties, taxes, or interest due if the litigant lacks the resources to engage in protracted litigation with the IRS.

For California Attorneys: Taxing Workplace Settlements

( April 2015 ) Although most cases are resolved by settlement, not every lawyer appreciates the tax ramifications of settlement payments, particularly in the context of employment litigation. Payments made pursuant to an employment-related settlement fall into the following categories:

wages or salary, subject to W-2 reporting;

neither wages nor salary, but income that must be reported to taxing authorities;

payment that is not income but must be reported; and

payment that is not income and need not be reported.

When a case is resolved, it is crucial for employers, employees, and counsel to understand the tax implications. They should know which portions of a settlement are subject to taxation and the proper procedures for complying with both the Internal Revenue Code (tax code) and the Regulations of the Internal Revenue Service (Treas. Regs.). Employers settling employment-related claims may have to pay payroll taxes, take proper withholdings, file information returns for 1099 income-or none of the above, depending on the circumstances. The improper characterization of a payment could result in an unwanted tax controversy with the IRS, not to mention substantial monetary consequences. The best approach is to know the rules and plan accordingly, so both sides can negotiate a fair settlement that will truly end the dispute.

Is It Taxable?

To begin with, it is important for employers to distinguish between taxable and nontaxable settlement payments. That’s because employers that misclassify settlement payments as 1099 income instead of W-2 income can be liable for the unpaid tax burden of the settlement proceeds, interest, and penalties (26 U.S.C.§3509; see also Treas. Reg. § 31.3403-1) (26 U.S.C. §§ 3509, 6651(a)(2) and (3), and 6656(a)).

The general rule for employers is that all payments to employees are taxable, unless the income is exempted by a specific section of the tax code. (26 U.S.C. § 61.) Whether payments are subject to taxation as wages or salary (requiring withholding and payment of payroll taxes), or as 1099 income (no withholding) depends on the reason for the payment and, in some cases, how it’s characterized in settlement documentation. (See Parkinson v. Comm’r, 2010 WL 2595005 (Tax Ct. Mem. Decis.))

The central question in determining whether a payment is taxable is: In lieu of what was the settlement amount paid? (Bagley v. Comm’r, 105 T.C. 396, 406 (1995), aff’d, 121 F.3d 393 (8th Cir. 1997).) Accordingly, allotting portions of the settlement payment to specific damages alleged by the former employee will help employers determine which portions of the settlement payment are taxable.

Here we review several of the more common items, along with their tax implications.

More about Workplace Settlements for Lawyers

Lost Compensation

When employees seek damages from their former employer, they usually do so via a variety of claims, such as breach of contract, unpaid overtime, and alleged work “off the clock.” (Cal. Lab. Code §§ 510 and 512.) Lost compensation claims may seek back pay for wages the employee did not receive for work performed; they may also involve work that should have been performed, in which case the monetary recovery is referred to as “front pay” for wages that would have been earned but for the employer’s allegedly unlawful action.

Settlement payments for lost compensation are generally taxable to the employee and deductible to the employer. Withholdings and the payment of payroll taxes are required when settlement payments are made for lost compensation.

Interest Income

When settlement dollars compensate an employee for lost interest, the payment is treated as taxable income to the recipient. However, interest payments are not subject to payroll taxes or withholding. (Greer v. Comm’r, 2000 WL 37725 (Tax Ct. Mem. Decis.).) Interest income must be documented in a Form 1099. (26 U.S.C. § 6041; Treas. Reg. § 1.6041-1(b))

Physical Injury

The tax code expressly excludes from gross income those payments intended to compensate litigants for “injuries” or “sickness.” (26 U.S.C. § 104(a)(2).) Congress amended section 104 in 1996 via the Small Business Job Protection Act (Pub. L. No. 104-188), adding the word physical to qualify the words injuries and sickness. Thus, settlement payments for damages relating to alleged physical injury or physical sickness are not taxable. (See H.R. Rep. No. 104-737, at 301 (1996) (Conf. Rep.) (providing an example that damages received for a loss-of-consortium claim due to the physical injury or physical sickness of a spouse are excludable from gross income))

In addition, settlement payments received on account of personal physical injury or physical sickness are not reportable as 1099 income. (The IRS offers a helpful publication: “Lawsuits, Awards, and Settlements Audit Techniques Guide.”) Although section 104(a)(2) of the code does not define “physical injury” or “physical sickness,” the IRS has provided some guidance, noting that “physical injury” requires either observable or documented bodily harm, such as bruises, cuts, swelling, or bleeding. (See IRS Ofc. of Chief Counsel Mem. 2009-035 (Oct. 22, 2008).) The IRS has also said that a settlement payment made to compensate for alleged loss of consortium, survival, and wrongful death would not be taxable because the claims arose from the physical sickness of the claimant’s husband: cancer, caused by asbestos fiber inhalation. (See I.R.S. Priv. Ltr. Rul. 200121031, 2001 WL 564931 (Feb. 26, 2001).)

Development of Workplace Settlements for Attorneys

Emotional Distress

Section 104(a)(2) specifically provides that emotional distress is not to be treated as a physical injury or physical sickness. Because no statutory exemption is available, settlement payments that compensate for emotional distress are generally taxable-even when physical symptoms occur as a result of the emotional distress. (See Shelton v. Comm’r, 2009 WL 1456477 (Tax. Ct. Mem. Decis.).) The legislative history of the Small Business Job Protection Act of 1996, and tax court cases, note that the symptoms of emotional distress can include but are not limited to insomnia, headaches, stomach disorders, depression, skin irritation, appetite loss, asthma, and sleep deprivation. (See H.R. Rep. No. 104-737, at 301 n. 56 (1996) (Conf. Rep.), 1996-3 C.B. 741, 1041; see also Lindsey v. Comm’r, 2013 WL 1052772 (Tax. Ct. Mem. Decis.))

Tax courts have recognized two separate exceptions to this rule. Payments for emotional distress will not be taxable:

if the damages are caused by a physical injury or physical sickness; and

to the extent the damages do not exceed payments made for medical care attributable to emotional distress.(Moulton v. Comm’r, 2009 WL 416010 (Tax. Ct. Memo. Decis.); see also Smith v. Comm’r, 2014 WL 4652904 (Tax. Ct. Summ. Op.))

Therefore, if the individual’s claims of emotional distress are attributable to a physical injury or physical sickness, the settlement payment can be treated as compensation for physical injuries or physical sickness-and the payment will be exempt from taxation under section 104(a)(2) and need not be reported. (See Conf. Rep. at 301 n. 56; IRS Publication 4345 (Rev. Nov. 2011))

With regard to the second exception, “the exclusion from gross income specifically applies to the amount of damages received that is not in excess of the amount paid for medical care attributable to emotional distress.” (See Moulton, 2009 WL 416010 at *4)

If neither of these two exceptions applies, any emotional distress payment is income and must be reported in a Form 1099.

Punitive Damages

Punitive damages are generally taxed as part of gross income, but they are not subject to payroll taxes. Even when awarded in connection with settlement payments for physical injuries and physical sickness, punitive damages are not excluded from gross income. (See Greenberg v. Comm’r, 2011 WL 240101 (Tax. Ct. Memo. Decis.).) This rule is set forth specifically in the code; the section 104(a)(2) exclusion is for payments “other than punitive damages.” Punitive damages received in a settlement payment are reportable as 1099 income.

Although generally not applicable in the employment context, an exception to this general rule is a wrongful death case. (See 26 U.S.C. § 104(c)(1).)

Details

Attorneys Fees

All parties should be aware that the payment of attorneys fees is generally taxable to the litigant, regardless of the type of fee arrangement-whether hourly, flat, or contingent. This rule applies even if the fees are not paid directly to the litigant. (See Treas. Reg. § 1.6041-1(f); Comm’r v. Banks, 543 U.S. 426, 430 (2005).) Attorneys fees are taxable to the claimant and reportable as 1099 income, but they are not wages and are not subject to tax withholding. (See Rev. Rul. 80-364 (1980))

Liquidated Damages

Liquidated damages included in a settlement agreement do not constitute wages for federal employment tax purposes, even if they are owed for a violation of the Fair Labor Standards Act of 1938. (See Rev. Rul. 72-268 (1972).) Accordingly, though employers are not required to take tax withholdings from portions of the settlement payment that provide for liquidated damages, those portions of the payment are still reportable as 1099 income to the claimant.

Reporting, Withholding, and Payroll Taxes

As noted, employers are required to report settlement payments to the IRS depending on the characterization of, and intent behind, the settlement proceeds. Payments that compensate a litigant for wage-related losses must be reported in a Form W-2, just as if they were paid by the employer for regular hours worked. (See 26 U.S.C. § 6051; Treas. Reg. § 31.6051-2(a).) Employers will accordingly deduct applicable taxes and withholdings (for Social Security, Medicare, and the like), and must pay the matching taxes to the IRS. (See 26 U.S.C. § 3402(a).) The Supreme Court has ruled that payroll taxes relating to a back-pay settlement are based on the year that the employees received the money, not the year in which the wages should have been paid. (See United States v. Cleveland Indians Baseball Co., 532 U.S. 200, 219 (2001))

If a settlement payment constitutes taxable income but is not allocated to lost wages-such as a payment for physical injuries, punitive damages, liquidated damages, and interest-it needs to be reported in a Form 1099. (See 26 U.S.C. § 6041; Treas. Reg. § 1.6041-1(b))

But if the payment is not taxable at all, the employer doesn’t have any reporting, withholding, or payroll tax obligations.

More about the Issue

Best Practices

Often employers agree to pay a single lump sum to settle multiple types of damages. If only a portion of the settlement payment is taxable, how is the employer to determine the extent of its reporting, payroll tax, and withholding obligations? Here are several steps to take.

First, employers should make sure that the settlement agreement expressly states the allocation of the payment(s). This practice is strongly encouraged because a settlement agreement entered into between adversarial parties in good faith and at arm’s length-which expressly allocates the settlement proceeds among multiple types of claims or damages-is generally binding for tax purposes. (See Bagley v. Comm’r, 105 T.C. 396, 406 (1995), aff’d, 121 F.3d 393 (8th Cir. 1997))

The parties may also choose to submit the settlement agreement to a court to confirm that the allocation of damage amounts is reasonable. Court approval of the settlement agreement decreases the likelihood of a challenge to the allocation of the settlement payment because it lessens the appearance that the litigant and employer colluded to gain the most favorable tax status. Such challenges are more likely to arise when very little of the settlement payment is allocated to wages. Accordingly, a court’s approval will assist the parties in negating any adverse inference by the IRS. If the parties do not specify the allocation of a lump sum settlement payment, the IRS will determine the allocation by reference to the underlying nature of the claims alleged and to the evidence of the payor’s intent in settling those claims. The tax courts will determine the payor’s intent by reviewing “all the facts and circumstances of the case, including the complaint that was filed and the details surrounding the litigation.” (Domeny v. Comm’r, 2010 WL 114287 (Tax Ct. Memo. Decis.).) Though the IRS is less likely to accept an after-the-fact allocation made by the parties, it may be sustained if there is contemporaneous, extrinsic evidence (such as attorney notes, settlement offers and counteroffers, or interrogatory responses) to support it.

Employers may further protect themselves from incurring additional tax liabilities, financial penalties, and interest payments by including an indemnity clause in the event the settlement allocation is challenged. The clause should note that the litigant will be responsible for any taxes, penalties, or interest assessed against either the litigant or the employer as a result of the settlement, and that the claimant agrees to indemnify, defend, and hold harmless the employer for any such taxes, penalties, or interest resulting from the settlement agreement.

Note, however, that a promise of indemnification is only as good as the assets of the indemnifier. The employer may still be held liable for any penalties, taxes, or interest due if the litigant lacks the resources to engage in protracted litigation with the IRS.

Despite the foregoing, it’s not just doom and gloom-tax wise-for the employee who recovers a settlement. When Congress passed the American Jobs Creation Act of 2004 it enacted section 62(a)(20) of the tax code, which provides for an above-the-line deduction for attorneys fees and court costs paid in connection with discrimination and certain other suits. In 2006 another provision was added to expand this rule to whistleblower cases. (See 26 U.S.C. §§ 62(1)(20) and (21).) So although the employee must acknowledge the income flowing from the settlement of an employment dispute, there is also available a deduction for certain attorneys fees and costs.

The key is to properly account for everything.

More about the Issue

Underpayment Interest Rates

This is a Non Profit Project. We don't collect personal data and we don't use cookies.

Underpayment Interest Rates in California

California Underpayment Interest Rates

California interest rate compounds daily and is adjusted twice a year.

Year Qtr 1
1/01 – 3/31
Qtr 2
4/01 – 6/30
Qtr 3
7/01 – 9/30
Qtr 4
10/01 – 12/31
2014 3% 3% % %
2013 3% 3% 3% 3%
2012 4% 4% 3% 3%
2011 4% 4% 3% 3%
2010 4% 4% 4% 4%
2009 5% 5% 5% 5%
2008 8% 8% 7% 7%
2007 8% 8% 8% 8%
2006 6% 6% 7% 7%
2005 4% 4% 5% 5%
2004 5% 5% 4% 4%
2003 6% 6% 5% 5%
2002 7% 7% 6% 6%
2001 9% 9% 9% 9%
2000 8% 8% 8% 8%
1999 8% 8% 7% 7%
1998 9% 9% 9% 9%
1997 9% 9% 9% 9%
1996 9% 9% 9% 9%
1995 8% 8% 9% 9%
1994 7% 7% 7% 7%
1993 8% 8% 7% 7%
1992 10% 10% 9% 9%
1991 11% 11% 10% 10%
1990 11% 11% 11% 11%
1989 11% 11% 12% 12%
1988 11% 10% 10% 11%
1987 8% 8% 8% 10%
1986 10% 10% 9% 9%
1985 13% 13% 11% 11%
1984 11% 11% 11% 11%

A TaxAlmanac user was kind enough to contribute these rates:

From To Rate
July 1, 1983 December 31, 1984 11%
March 1, 1983 June 30, 1983 16%
January 1, 1983 February 28, 1983 14%
May 27, 1982 December 31, 1982 18%
January 1, 1976 May 26, 1982 12%
Prehistory January 1, 1976 6%

Source: California Franchise Tax Board

Federal Underpayment Interest Rates

The interest on underpayments of federal tax must accrue interest, compounded daily, at rates published quarterly by the Internal Revenue Service.

For further information, see the entry about Federal Underpayment Interest Rates in the Encyclopedia, which includes federal interest rates either charged or paid by the IRS (for overpayment or underpayment of taxes), as well as links to other states.

Net Operating Loss

This is a Non Profit Project. We don't collect personal data and we don't use cookies.

Net Operating Loss in California

Tax Law: California Net Operating Loss Deductions Suspended then Reinstated

For tax years beginning in 2002 and 2003, California suspended the Net Operating Loss (NOL) carryover deduction. NOLs generated during these tax years continued to be computed and carried over. Disaster losses were not affected by this suspension. The carryover period for suspended losses was extended by two years for losses incurred before January 1, 2002 and by one year for losses incurred after January 1, 2002 and before January 1, 2003.

For taxable years beginning on or after January 1, 2004:

  • California has reinstated the Net Operating Loss carryover deduction
  • 100% of the Net Operating Loss may be carried forward for ten years

Tax Relief

This is a Non Profit Project. We don't collect personal data and we don't use cookies.

Tax Relief

California Military Family Tax Relief Act

California Military Family Tax Relief Act Conformity

California does conform to the Military Family Tax Relief Act of 2003 that was signed into law on November 11, 2003. This legislation provides for the exclusion of gain from the sale of a principal residence by military and Foreign Service personnel, above-the line-deductions for overnight travel expenses of National Guard and Reserve members, and various other exclusions and rulings benefiting military families.

California allows the exclusion of the gain from the sale of a principal residence if the seller was in the military and qualifies for the exclusion under federal law. California also allows the deduction for business expenses of reservists reported on Form 1040, Line 24. This deduction is included in federal AGI reported on Form 540, Line 13.

Savings Account

This is a Non Profit Project. We don't collect personal data and we don't use cookies.

Savings Account in California

Tax Law: California Health Savings Accounts Conformity

California does not conform to the portion of §223 of the IRC that permits eligible individuals to establish Health Savings Accounts (HSA’s) for taxable years beginning on or after January 1, 2004. This was added in the Medicare Prescription Drug, Improvement, and Modernization Act of 2003. For federal purposes, HSA contributions are deductible from AGI, the contributions grow tax-free over the years, and amounts can be distributed tax-free to pay or reimburse qualified medical expenses.

California requires that the deduction for HSAs claimed on the federal return (Form 1040, Line 28) be added back on Schedule CA or CA-NR, Line 28. Also, earnings from an HSA and rollovers from an MSA to an HSA are added to income on Schedule CA or CA-NR.

Tax Incentive

This is a Non Profit Project. We don't collect personal data and we don't use cookies.

Tax Incentive in California

California and the American Jobs Act of 2004 Conformity

California does not conform to the American Jobs Act of 2004 that was signed into law on October 22, 2004. This legislation provides for various business tax and agricultural tax incentives, deduction of state and local general sales taxes and various other provisions. This includes the following provisions:

  • The exclusion of gain on sale of a principal residence does not apply if the principal residence was originally acquired in a like-kind exchange in which any gain was not recognized within the prior five years.
  • A tax deduction for charitable contributions of patents and similar intellectual properties is allowed on form 8283.
  • A taxpayer can expense up to $5,000 of business start-up costs under IRC §195(b) up to $5,000 of organizational costs under IRC §§248(a) and 709(b).
  • Individuals may elect to deduct state sales and use taxes rather than state and local income taxes on their federal returns on Schedule A, line 5b.

California allows the exclusion of the gain from the sale of a principal residence if the residence was acquired in a like-kind exchange. The gain is subtracted from California taxable income on Schedule CA or CA-NR, Line 13. California requires that any deduction recognized on the federal return for charitable contributions of patents be subtracted from CA itemized deductions on Schedule CA or CA-NR, Line 40. Start-up and organizational costs allowed on the federal return are added back to business income on Schedule CA or CA-NR. The deduction for state sales and use taxes allowed on Schedule A, Line 5b is added back to the CA itemized deductions on Schedule CA or CA-NR, Line 38.

Conformity

This is a Non Profit Project. We don't collect personal data and we don't use cookies.

Conformity in California

State Law: California – IRC Conformity Date

State Tax conformity means that a state “conforms” or abides by the federal tax code as it relates to tax concepts and definitions of income. This is applicable to both businesses and individuals.

Most states conform in some manner, but to varying degrees. There is automatic or “moving date” conformity, which means that changes in federal tax law automatically apply to the state tax code as they occur. Another scenario is “fixed date” conformity, meaning that a state conforms to the federal code as it existed on a certain date. For example, if a state conformed as of January 1, 2001 it would mean that the state does not automatically incorporate federal tax law changes occurring after that date.

California is a “fixed date” conformity state. Currently this “fixed date” is January 1st, 2005. Cal. Assembly Bill 115, signed by Gov. Schwarzenegger on 10/7/2005.