Wages Increasing But So Are Taxes On Damages


The enactment last summer of federal legislation increasing the minimum wage was a welcome relief to many employees. The measure, however, is unwelcome news for many employees and employers as well.

Tucked into the law raising the minimum wage from $4.25 to $4.75 is a provision that makes most employment severance and settlement arrangements taxable. Under prior law, settlement agreements between employers and employees in connection with termination of employment often could be treated as nontaxable. A tax-free settlement, in whole or in part, could be achieved by characterizing the payment as being made in connection with emotional distress, mental suffering, or other noneconomic harm. By structuring a severance payment or workplace settlement in this way, the proceeds could be treated comparably to payment of a personal injury claim, which generally was nontaxable under ยง104(a)(2) of the Internal Revenue Code and also immune from income taxes in Minnesota.

The amended law eliminates nontaxability in most circumstances. Under the new law, damages for emotional distress are generally taxable unless they are accompanied by an actual physical injury. This will preclude shielding many employment-related settlements from taxes, as was commonly done in the past. The law also makes punitive damages taxable in nearly all circumstances, except some wrongful death cases.

This measure is likely to have an impact on employees who strive to maximize severance payments or other workplace settlements. Under pre-existing law, the nontaxable payments allowed employees to accept a lower amount to settle a case. Employers benefitted, too, because the payments were not subject to FICA or other wage withholding. Therefore, employers generally were willing to pay a bit more money for severance, or as part of a settlement.

Those incentives, however, are largely eroded by the new law. The effect could be harmful to both employees and employers. Employees will generally strive for higher settlement amounts in order to make up for the tax burden. Employers, too, may be harmed because the costs of settlement will be driven up by the new measure. Settlements may be harder to achieve, which would result in more prolonged and costly litigation.

The new restriction is an evolution of a concept that has grown in the last few years. The Internal Revenue Service, bolstered by some favorable court rulings, has increasingly taken the position that employment-related severance payments or settlements are fully taxable.

Employees have resisted, often by structuring settlement payments in a way that characterizes the payment as attributable to a personal injury tort. In discrimination and harassment cases, settlements also have often been framed as payment for emotional distress or mental suffering, which is permissible under the Minnesota Human Rights Act and, therefore, insulated from taxation.

The new law does not totally foreclose the opportunity to structure settlements creatively in the workplace to maximize tax benefits for both employees and employers. When some degree of physical injury is present, often corroborated by medical records, nontaxability may still be achievable. However, the likelihood of achieving a tax-free settlement for a workplace dispute definitely will be harder to come by, and harder to sustain, in light of the new law. In addition to effecting workplace disputes, the new law may have an impact on other legal claims as well. The new imposition of taxes on most punitive damages could effect the outcome of some cases, and the elimination of the tax immunity also will effect defamation claims, which generally have not been fully subjected to taxation in the past.

So, while compensation increases for those employees in the workplace drawing minimum wages, those exiting from the workplace are likely to suffer an economic disadvantage because of the new law.

*article courtesy of Mansfield, Tanick & Cohen, PA, mtinfo@mansfieldtanick.com.