Tax Withholding on Settlement Awards

There are quite a few court cases that address whether a lawsuit settlement award is taxable. Section 104 excludes some damage payments for income tax purposes. But what about withholding taxes?

Assuming that the payment or award is taxable, can the award escape withholding tax? One might think that this turns on whether the award was made for lost wages. While this may be one factor, it is not determinative. And yes, this is frequently the subject of IRS audits and can result in significant tax penalties.

The court recently addressed this in Rivera v. Baker West, Inc., 430 F.3d 1253 (9th Cir. 2005), which is a must-read for those who receive settlement awards.

Facts & Procedural History

Jack Rivera filed a lawsuit against Baker Concrete Construction, Inc. for workplace discrimination and wrongful termination. The parties reached a settlement agreement, and Baker paid Rivera $25,140 after withholding $14,860 for taxes.

Rivera argued that the settlement proceeds should be excluded from his gross income, but the district court disagreed, finding that the settlement proceeds represented lost wages and were subject to withholding. The court dismissed Rivera’s suit, and he appealed. The appellate court had to decide whether the settlement proceeds were taxable wages and whether the withholding was proper.

Settlement Payment for Lost Wages

Rivera argued that the settlement proceeds paid by Baker were intended to reimburse him for personal physical injuries, and therefore should be excluded from his gross income under Section 104(a)(2).

Section 104 provides an exclusion of certain types of damages or compensation from gross income for tax purposes. Specifically, Section 104(a)(2) provides an exclusion for “the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.”

This means that compensation received as a result of a personal injury or physical sickness is generally not considered taxable income. There have been quite a few court cases that address what counts as personal injury and what counts as physical sicknesses, such as whether diabetes qualifies and whether repeated injury lawsuits qualify.

On appeal, the appeals court noted that Rivera argues that his discrimination claim was a “personal injury claim” and that Baker knew or should have known of the nature of his claim, but the court found no support for his argument. The complaint did not allege any physical injury or sickness, and Rivera did not disclose any physical injury or sickness as a category of damages for which he sought relief. Rivera also failed to produce any evidence regarding the settlement conference during which the parties allegedly discussed Rivera’s emotional distress and mental anguish. Therefore, the court concluded that Rivera did not satisfy the requirements of Section 104(a)(2).

Withholding on Settlement Award Payments

The appeals court then took up Rivera’s argument that even if the payments were taxable, they were not subject to withholding.

The tax code defines “wages” as all remuneration for employment, including the cash value of all remuneration paid in any medium other than cash. The tax code does not distinguish between back pay based on, for example, contract claims, and back pay based on Title VII claims. Settlement payments based on Employee Retirement Income Security Act (“ERISA”) claims are also considered “wages” subject to FICA taxes.

In this case, Rivera’s claims stem from his employer-employee relationship with Baker, and the settlement payments are compensation for back pay and lost wages. The appeals court concluded that just because back pay was owed to Rivera because of violations of federal discrimination laws is incidental to whether his back pay constitutes wages subject to withholding. The court concluded that Rivera’s back pay and lost wages constitute “wages” for taxable withholding purposes, and the district court properly held that these settlement payments were subject to withholding.

The Takeaway

If settlement proceeds are intended to reimburse an employee for lost wages due to workplace discrimination, then they are subject to tax withholdings. It is not necessary to withhold taxes if the payment is not taxable. Typically, compensation received due to personal injury or physical sickness is excluded from taxable income if it meets the requirements of Section 104(a)(2). To qualify for the exclusion, the taxpayer needs to allege and prove physical injury or sickness.