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Trotter involved a typical employment related class action, in which the plaintiffs sought back pay and certain benefits.
The settlement agreement allocated money based on hours worked and years of service.
From a taxing agency perspective, the primary concern with respect to an employer and a settlement agreement is whether a reasonable amount was allocated to wages, and thereafter the correct amount of taxes was withheld and remitted.
To the extent that there may be multiple allocations for non-wage (but taxable) payments, there is little incentive for the taxing agency to address the matter with the employer, so long as it was reported on a Form 1099-MISC if more than 0 in total.
In two consolidated cases in 2005, the United States Supreme Court ruled that attorney’s fees are taxable income to the plaintiffs. Therefore, attorney’s fees should be reported on a Form 1099-MISC, box 3, to the plaintiffs.
In addition, to the extent income is reported to an attorney, such income is reported on Form 1099-MISC, box 14, to counsel. Congress alleviated the problem of plaintiffs being taxed on attorney’s fees in most employment litigation in the JOBs Act of 2004.
In some cases, despite claims for back pay, the facts will demonstrate that the employee lost little in wages, either because he or she remained employed or obtained other employment quickly for the same or more pay.  See, e.g., 2013 Form 1099-MISC Instructions (liquidated damages under ADEA not wages); Rev. 72-268 (liquidated damages are not wages subject to employment taxes); Kern v.
In such situations the amount of a settlement reasonably allocated to wages may well be small relative to other payments made.
An emotional distress payment, while taxable income, is not wages, as it is not intended to be in lieu of wages paid in employment. Most settlements involve some payment of attorney’s fees.For example, claims under the ADEA do not allow tort damages, and therefore no amount could be allocated to a claim under the ADEA for personal physical injuries. Once the claims and potential damages are determined, the relative strength of any claims should be reviewed. For example, under California law, when there is no contract providing for the disposition of such fees, they belong to the attorney that earned them. The IRS takes the position that even attorney’s fees paid under a fee shifting statute are still income to the plaintiff.  There is also currently an administrative exception to the rule that attorney’s fees are income to the plaintiffs in claims made class action settlements. While the legal justification for IRS position is somewhat suspect, because it benefits taxpayers, it has not been challenged. For example, a claim for back pay must be determined in light of whether the employee continued to be employed during the period at issue. See Office of Chief Counsel Memorandum, PRENO-111606-07, May 18, 2007. This article provides a short primer on common tax issues associated with these cases.As the IRS and state tax agencies are not parties to settlements, they are not required to respect the tax consequences inherent in such settlements.In addition, the named plaintiffs were each to receive a ,000 incentive payment for the risk of stepping forward and being involved in the litigation process.While in Trotter the court held that incentive payments were wages, the court’s decision was based in part upon: the fact that the only underlying claim was for wages; the Allocation Plan did not specifically allocate these payments separately; no claim had been made in the complaint for a separate payment; and the fact that the allocation was based on factors that could have included work on the lawsuit.A plaintiff may deduct attorney’s fees paid for discrimination cases that is above-the-line, making it potentially tax neutral, but only up to the amount of the settlement award. This provision applies to payments made after October 22, 2004. In Revenue Ruling 80-364, the IRS explained the income and employment tax consequences of interest and attorney’s fees being awarded by a court in connection with claims for back pay.Specifically, it stated that interest and attorney’s fees are generally not wages to the employee unless there is no specific allocation. Liquidated damages and interest are treated as taxable income but not wages. There is little authority regarding whether incentive payments to named plaintiffs are treated for tax purposes. Rankin a federal district court held that ,000 incentive payments made to class representatives were “wages,” and therefore subject to employment taxes.The court held California Labor Code section 226.7 to be a “wage” rather than a penalty, while contrasting it with California Labor Code section 203, which it described as clearly being a penalty. While there have been a number of cases on the subject of whether the payment of an additional hour of pay per California Labor Code section 226.7 when a meal or rest period is not provided should be characterized as a wage or a penalty, the taxing agencies expect these payments to be processed as wages.In most cases, however, penalties, if paid directly to employees, should be treated as income but not wages.