Terminating the Employment Relationship

E. T AXATION OF M ONEY P AID P URSUANT TO AN A GREEMENT A frequent hurdle to settlement and separation agreements is resolving how the parties will treat taxation of money paid to a former employee. Former employees and plaintiffs often want to treat settlement money as compensation for personal injury or emotional distress. By doing so, they believe they can avoid reporting the money as “income” fo r tax purposes, thereby allowing them to keep most, if not all, of the settlement money. Although treating a settlement payout as compensation for personal injury or emotional distress is acceptable in certain circumstances, it can lead to tax penalties for an employer and the former employee if the money is actually compensation for wages. If an employer needs advice regarding tax consequences of an agreement, the employer should consult a tax attorney. Tax advice from an attorney who does not practice tax law can jeopardize an attorney’s license to practice law and will not insulate an employer from adverse tax consequences or penalties if the IRS or Franchise Tax Board does not concur with how an employer has treated a payout in a settlement agreement. Nonetheless, the law clearly does not allow parties to subvert or circumvent tax laws via an agreement. Consequently, if an agreement requires payment of wages – whether they are back or front wages – parties should not attempt to characterize the wages as another form of damages to avoid deducting payroll taxes. An agreement involving payment to an employee/ex-employee can contain language that shifts the responsibility of the employee/ex- employee’s tax burden to the employee/ex -employee. In an effort to protect an employer from adverse tax consequences that result from an employee/ex employee’s failure to pay tax on the money the employee has received, an employer should include a provision that puts the onus on the employee/ex-employee to determine the taxation of the payment issued to the employee. The following is sample language regarding shifting the responsibility of the tax burden to the employee/ex-employee:

Jones acknowledges and agrees that the City has made no representations to him regarding the tax consequences of any amounts received by him pursuant to this Agreement. Jones agrees to pay federal, state or local taxes, if any, which are required by law to be paid with respect to this settlement. Jones further agrees to indemnify and hold the City harmless from any claims, demands, deficiencies, levies, assessments, executions, judgments, or recoveries by any governmental entity against the City for any amounts claimed due from Jones related to the monies paid on account of this Agreement and for any costs, interest, expenses, fines, penalties, attorneys’ fees or damages incurred or sustained by the City by reason of Jones’ failure to pay such taxes.

Terminating the Employment Relationship ©2022 (s) Liebert Cassidy Whitmore 121