Supreme Court to Look at Tax Treatment of Age Settlements

April 1, 1995 Advisory

Any employer that has ever tried to settle an employment discrimination claim has struggled to determine whether payroll taxes need to be withheld, sometimes holding out a "no-tax" treatment as leverage to get an employee to accept a lower fee settlement figure.

Until about one year ago, this could be a risky proposition because employment discrimination settlements of all kinds were generally understood to be back wages subject to tax as if they were paid in the employee's normal paycheck. If no taxes were withheld, not only would the employee be liable for back taxes, the employer could face severe penalties for its failure to make the proper withholding.

The 1991 Civil Rights Act Changed Income Taxation
Title VII of the Civil Right Act of 1964, which prohibits discrimination on the basis of sex, race, color, religion and national origin, historically provided only make-whole relief such as reinstatement, back pay and lost benefits, rather than tort or personal injury type damages in the case of employment discrimination awards. That changed, however, with the passage of the Civil Rights Act of 1991, which now provides for the first time a right to jury trials and compensatory and punitive damages in Title VII cases.

In view of this development, the Internal Revenue Service issued a ruling in December I993 stating that back pay and compensatory damages received under Title VII would no longer be subject to income tax. The IRS reasoned that the new Title VII damages, authorized by the Civil Rights Act of 1991, were now more like traditional tort-type remedies and should be excluded from income as personal injury damages, even back pay. The IRS applied the same reasoning to the Americans with Disabilities Act.

The IRS was silent, however, on the issue of age discrimination claims which are governed by an altogether different statute, the Age Discrimination in Employment Act (ADEA).

U.S. Supreme Court to Decide Whether Age Claims are Subject to Income Tax
The United States Supreme Court recently agreed to hear Commissioner of Internal Revenue v. Schleier to decide whether back pay and liquidated damages received in settlement of an ADEA claim are subject to income tax, or whether they are properly excluded from income as "personal injury" damages, as is now the rule under Title VII and the Americans With Disabilities Act.

Until the Court rules, employers who seek to settle age bias claims will be faced with the same tax dilemma. Since age bias claims are often filed along with other claims that are clearly non-taxable, such as Title VII, ADA, emotional distress and defamation, conservative employers may be able to avoid the tax risk by negotiating an apportionment of any settlement figure into a taxable portion that settles the age claim and a non-taxable portion for the other claims.

In such a negotiation, the employee usually wants as much of the apportioned settlement as possible to be non-taxable to maximize his/her recovery. The employer must be careful, however, that any negotiated apportionment between age and other claims realistically reflects the allegations that were made by the employee, and is not arbitrarily drawn for the purposes of clinching the settlement.