Navigating the minefield: Hidden taxation, IRS reporting in employment settlements

Many businesses are familiar with the reasons that drive settlements in employment lawsuits. Even in cases when the facts generally support the employer’s version of events, practical considerations, such as avoiding the time and cost of protracted litigation, often lead businesses to reach reasonable settlements with former (or even current) employees. So, the lawyers and their clients put down their proverbial swords, and they get to work on drafting a written settlement agreement. What’s often overlooked in this process, however, is the taxation of the settlement payments. Here are some key issues to consider before signing a final settlement agreement.

Taxation of settlements, generally

Settlement payments are almost always taxable to the recipient, particularly in the context of an employment lawsuit.

If some or all of the settlement proceeds are attributable to alleged lost wages, then the business is obligated to withhold income and employment taxes as required by law and issue a Form W-2 to the employee (or former employee) for that portion of the payment.

Emotional distress versus actual physical injury/sickness