In accordance with State Human Resources Regulations Section 19-718.11 all personnel settlements must be approved.
Tax Implications for Personnel Settlements
The Internal Revenue Service (IRS) can impose fines or penalties on agencies if the parties to the settlement do not determine the taxation of the lump sum amount properly. Before agreeing to a lump sum amount, agencies should become familiar with the methods for determining the proper taxation of personnel settlements to avoid any potential fines or penalties.
Settlements and judgments are treated similarly when it comes to taxation, and agencies must be aware that the IRS may impose severe penalties on employers who do not withhold mandatory deductions on wage based lump sum settlements or monetary judgments. The responsibility for determining whether the lump sum payment is wage based or non-wage-based is left to the parties named in the settlement.
Parties to a monetary settlement must first determine the reasons for the payment. This determination will assist in deciding whether the payment is wage-based or non-wage based.
If wage-based: The payment is subject to the standard state and federal withholdings. For example, FICA, FUTA, state unemployment tax, state income tax, and federal tax withholdings will be deducted. The employer is responsible for reporting the wage-based payment on a W-2 Form. Examples of wage-based payments may include: back wages, future wages, allegations of inequity in pay, and misclassification of position.
If non-wage based: These types of payments fall into several categories. Parties will need to determine which categories are appropriate based on the origin of the claim. These categories include:
- Physical Injuries -- Includes all physical injuries sustained by the party. It may also include pain and suffering resulting from physical injuries. Payments of this nature are non-taxable.
- Non-Physical Injuries -- Examples of non-physical injuries include defamation, conspiracy, and free speech violations. Payments of this kind are subject to income tax and should be reported by the employer on a Form 1099.
- Emotional Distress and Mental Anguish -- Parties should first consider whether the emotional distress is caused by a physical or non-physical injury. If the emotional distress is caused by a physical injury the payment is considered non-taxable. If, however, the emotional distress is caused by a non-physical injury, the payment will be taxable income. This income should be reported by the employer on a Form 1099.
- Other -- Fees such as court costs, attorney's fees, and interest are subject to tax and should also be reported on a Form 1099.
Again, the responsibility for determining whether the lump sum payment is wage-based or non-wage based rests with the parties involved in settling the dispute. To ensure that your settlement is allocated properly, parties should:
- Identify the basis for the payment
- Indicate the settlement amount
- Allocate in writing each dollar of recovery to the respective category
Agencies should maintain a file containing any documentation that supports the allocation of the settlement or judgment amount. Failure by the agency to allocate damages into categories will allow the IRS, at its discretion, to allocate damages or to treat the entire payment as back wages. This IRS allocation could result in additional employer liability for failure to withhold taxes, plus penalties and interest.
Most personnel settlements which contain lump sum amounts will be wage-based in nature. As stated earlier, these types of settlements will require an agency to withhold the standard State and Federal deductions prior to issuing a check for the lump sum amount. Agencies will be responsible for reporting the wage based portion of the settlement on the appropriate federal form. You may wish to contact the IRS or the South Carolina Department of Revenue regarding the reporting of tax information.
If you have any questions regarding monetary settlements and possible tax implications, please contact your agency's Human Resources Consultant for additional information.
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