an employee, the question arises as to whether the payment should be treated for income and FICA purposes as a wage or non-wage payment. And, if treated as a non-wage payment, how should it be classified? The recently released Program Manager’s Technical Advice 2009-035, provides a detailed account of the IRS’s position on how to handle the tax consequences of both these taxes as well as the related reporting duties. Although the memorandum addresses the employment related judgments and settlements that the IRS may make to its current or former employees, its conclusions (although they cannot be used or cited as precedent) are useful to any employer.

The memorandum provides that these determinations should be made under the following four-step process:

Step One: Determine the character of the payment and the nature of the claim that gave rise to the payment. The payment should be characterized as severance pay, back pay, front pay, compensatory damages, consequential damages, punitive/liquidated damages, or restoration of benefits. The memorandum then lists several statutes that could form the nature of the claim, including the Age Discrimination in Employment Act and Title VII of the Civil Rights Act of 1962.

Step Two: Determine whether the payment constitutes an item of gross income. An issue that often arises in these situations is whether the settlement or award can be excluded from the employee’s gross income under the IRC § 104(a)(2) exclusion for damages received on account of personal physical injuries or physical sickness. The memorandum discusses how the exclusion provision should be analyzed and applied.

Step Three: Determine whether the payment is “wages” for FICA and income tax withholding purposes. Assuming that the payment constitutes gross income, this section looks at whether it should be classified as wages and discusses such issues as how to treat severance pay and emotional distress awards and how allocations should be made between wage and non-wage payments that are part of the same award or settlement.

Step Four: Determine the appropriate reporting for the payment of any attorney’s fees that may be paid to or on behalf of the employee. This section of the memorandum discusses normal Form W-2 reporting for wages, special reporting rules that apply to payments of back pay, Form 1099 reporting for non-wage payments, and how the payment of the employee’s attorney’s fees, whether paid to the employee or directly to the attorney, should be reported. Finally, the memorandum lists for each different type of payment whether it constitutes taxable income, whether it should be treated as wages for FICA and income tax withholding purposes, and whether reporting is required and, if so, the proper form to use.

The information is presented in summary format on pages 15 through 20 of the memorandum which is posted on the IRS website here.

The bottom line is you cannot simply make a payment to a former employee, either as severance or to obtain a waiver of the right to bring a lawsuit, without considering how those payments should be characterized, whether any portion is subject to withholding, and what tax reporting forms (e.g., W-2 or Form 1099) must be used to report the payments to the IRS.

By Jeffrey C. Rambach, jrambach@dsda.com