Taxes On Back Pay

In April, the U.S. Supreme Court ruled that a back pay award or settlement must be taxed as wages in the year in which the amount is paid and may not be attributed to the prior years for which the amount was intended to be compensation. The case involved the Cleveland Indians baseball team which paid $2.7 million in back pay to 22 baseball players for salary that should have been paid 7-8 years earlier. Even though the back pay was for the prior years, the Supreme Court ruled that income tax, Social Security, Medicare and other taxes would have to be paid on the entire amount based on the year in which it was paid.

The decision is important because when employers pay severance or settle discrimination or wrongful discharge claims, the amount paid is taxable and generally must be treated as wages. Under the Internal Revenue Code, only when the amount paid is "on account of personal physical injuries or physical sickness" may the amount be excluded from gross income. Since cases of physical injuries are rare in the employment context, most settlement payments made to former employees must be treated as wages subject to all the normal payroll tax withholdings in the year in which they are paid.