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At times and for a variety of reasons, employers will opt to settle employment discrimination suits. Perhaps it is the fear of what a jury may do, perhaps it is just to “put the case to bed” or perhaps it is the result of the classic cost-benefit analysis. Whatever the reason, the case will be settled and money will be paid to the individual employee plaintiff. So, litigation has been threatened or filed. The parties have negotiated, and the parties have come to an agreement on the money to be paid to the employee . . . or have they? The employer will typically want to pay the settlement proceeds to the employee as W-2 earnings and, therefore, withhold taxes from the amount to be paid to the employee. Conversely, most employees will want to be “1099′d” and have the full amount of the settlement proceeds delivered. How should the money be handled? The first issue in how to handle the money turns on whether the settlement proceeds are for back pay or to compensate the individual for personal physical injuries or physical sickness that are the result of a tort-like personal injury. As practitioners in the labor and employment world know, most complaints contain ad damnum clauses that seek back pay and front pay as well as damages for the personal injuries that the individual plaintiff has suffered. For instance, most complaints will include a claim for damages related to, among other things, pain and suffering, mental anguish and humiliation. According to the U.S. Supreme Court and the Tax Code, settlements based on back pay will generally be considered income to the individual employee plaintiff. As such, such settlement proceeds are not excludable from the individual’s gross income. If, however, the settlement appears to be based on the individual employee’s personal injury or sickness, when such personal injury or sickness is the result of the employer’s actions, then the settlement proceeds attributable to such personal injury or sickness may survive scrutiny of being excluded from the individual’s income. As such, one is left to question whether the settlement proceeds in a case were intended to compensate the individual employee for past work lost or personal injury. Clearly, if the employee was making a certain amount of money in a given week and the settlement was negotiated to compensate the employee for the weeks lost or a portion of those weeks lost, that money would be considered lost wages. As lost wages, the settlement proceeds will be considered income to the employee. On the other hand, if the employee can show that he or she suffered a tort-like personal injury as a result of the employer’s actions, and the settlement proceeds are not clearly simply a multiplier of the employee’s lost time, then the employee may be able to exclude such proceeds from his or her income. Once it is decided what the basis of the settlement is, the question then becomes whether the employer should withhold taxes from the settlement proceeds. Although the case law on this issue appears to be muddled, it would seem that the safest course of action is for employers to withhold taxes when the settlement proceeds are for back wages and, in some jurisdictions, future wages. The more difficult withholding situation is when the settlement proceeds are possibly attributable to non-wage-related factors and to address an individual’s personal injury. If the settlement can truly be attributable to damages that resulted from a tort-like personal injury, then it would seem withholding would not be required. Such a determination must, however, be able to withstand an Internal Revenue Service audit. Thus, any connection between an individual’s settlement proceeds and his or her lost wages will risk a finding that the settlement proceeds should have been subject to withholding. In such situations, the IRS will generally look to the employer to pay the taxes that were not withheld. In situations where employees insist on the payment of the settlement proceeds with a 1099 form being issued by the employer, the employer may elect to try to protect itself from tax liability down the line by including indemnification language in the settlement agreement. Essentially, such language provides that, should any taxing authority determine that the settlement proceeds constitute wages, then the individual will be responsible for all attendant taxes and will indemnify the employer for any amounts that may be determined to be due and owing as taxes, interest, penalties and damages arising out of the payment of such settlement proceeds. Although this indemnification language can be helpful, it still requires the employer to pursue the employee to make good on the indemnification. Depending on the financial wherewithal of the employee, this may or may not be a losing proposition for the employer. Employers should consider this reality when deciding whether providing settlement proceeds through a 1099 form with an indemnification clause is truly a viable settlement option. In the end, the employer needs to weigh all factors in determining what terms of a settlement are acceptable - including how the settlement proceeds are to be distributed. At bottom, the issue of whether settlement proceeds will be considered income of an individual is a decision on which the individual’s tax adviser needs to provide counsel. With respect to the employer and the payment of settlement proceeds, the most conservative approach is for the employer to withhold all taxes. Unfortunately, this does not always allow for a settlement. If it is agreed that the settlement proceeds should be paid with the employer issuing a 1099 form, then the employer should include the indemnification language in the settlement agreement with the understanding that the employer may, at the end of the day, be liable for the taxes should the settlement proceeds be found to be payment for wages. Christina Michael, a summer associate with Mitts Milavec, assisted with the preparation of this article.Todd Alan Ewan is a partner in the labor and employment law practice group of Mitts Milavec. Ewan advises and counsels clients in various aspects of the employer-employee relationship, including personnel policies, employment contracts, severance agreements and noncompetition, nonsolicitation and nondisclosure agreements. Carolyn M. Plump is a partner in the firm’s labor and employment law practice group. Plump has successfully negotiated labor contracts, counseled clients regarding regulatory compliance, prepared corporate employment policies and handbooks, conducted investigations and advised companies regarding the hiring, firing and disciplining of employees. She has represented clients in litigation, mediation and arbitration matters in federal court and before administrative agencies.

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