Taxes are often overlooked when settling employment claims, but they can play a crucial role. When a former employee collects back pay as part of a legal settlement, for instance, those payments are still considered wages subject to withholding and payroll taxes.
The tax treatment of employment-related lawsuits and settlements is complicated. Tax treatment depends on whether payments are deemed front pay, back pay, lost wages, emotional distress, physical injury, compensatory damages, punitive damages, or attorneys’ fees. Some are taxable as normal income; some are completely tax-free. Some are wages subject to payroll tax withholding. Some are deductible by the employer; some are not. Some require W-2s; some require 1099s.
The parties should always discuss the tax treatment of any settlement beforehand so there aren’t any surprises down the road. The settlement agreement should also include a breakdown of the types of damages being paid, which must be reasonably related to the actual settlement.