Settlement Agreements and Taxation Technical Guidance

Authority

• U.S. Code, Title 26, §61, 104 (Internal Revenue Code) 
• Treasury Regulation 1.6041-1 Return of information as to payments of $600 or more 
• Treasury Regulation 1.6045-5 Information reporting on payments to attorneys 
• IRS Lawsuits, Awards, and Settlements Audit Techniques Guide 
• IRS Office of Chief Counsel Memorandum 10/22/2008
• IRS Office of Chief Counsel Memorandum 7/11/2013
• IRS Rev. Rul. 85-97, 1985-2 C.B. 50
• IRS Rev. Rul. 2004-110
• IRS Auditor guidance on taxability of COBRA payments for a separated employee – 9/22/2020
• CRS 24-10-100 et seq. Short Title (Governmental Immunity)
• CRS 24-10-114(4) and (5) Limitations on judgments
• CRS 24-30-202.4 (3.5) (a) Collection of debts due the state – state controller duties
• CRS 24-30-1501 et seq. Legislative declaration (Risk Management)
• CRS 24-30-1515 Compromise or settlement of claims – authority
• CRS 24-30-1520 Authorization by law to settle claims or to pay judgments
• CRS 25.5-4-301 Recoveries – overpayments- penalties- interest – adjustments – liens- review or audit procedures
• Section 111 of Medicare, Medicaid, and SCHIP Extension Act of 2007
• PERA – Retroactive Payment, Settlements, and Awards, S-139 (Rev 8/17)

Background

In FY2018, the IRS audited several employee settlement agreements that contained statements that the payment was a lump sum and was not Wages.  The IRS questioned whether Medicare and other taxes should have been deducted from the payments. To determine whether the payment should be treated as Wages, the IRS looked at the Complaint to see if Wages were claimed.  If so, the IRS Lawsuits, Awards, and Settlements Audit Techniques Guide requires treating at least a portion of the payment as Wages.  Based on this approach, if the Claimant claims Back Pay, Front Pay, or any other Wages, then all or part of the settlement payment will be for Wages.   

The Office of the State Controller (OSC) is providing this guidance to assist in determining the taxability of employment and tort settlement agreements, apportioning settlement payments, preparing the employee settlement payment paragraph, reducing the settlement for amounts owed to the State, and determining the withholding for Medicare tax, PERA contributions, and benefits.  The guidance includes examples of taxable and non-taxable claims and flow charts for the settlement process and allocation of the settlement payment.

Definitions - IRS Code and Related Concepts

• Attorney’s Fees - Under Treasury Regulation 1.6045-5, attorney’s fees are always taxable to the attorney, and taxable to the claimant if the claim is taxable.
• Back Pay – Term used to denote settlement where a Claimant’s Complaint requests Wages and the settlement dollar amount is payment of Claimant’s salary for a specific, articulated, time period.  Back pay requires a PERA contribution and deduction.  3. COBRA Payment – The term used in an employee Voluntary Separation Incentive Agreement (VSIA), Severance Agreement or Settlement Agreement where the State employer pays the COBRA Administrator for all or a portion of the health insurance premium for a separated employee during the period the coverage for the separated employee is in effect.  The COBRA payment is not taxable to the separated employee. 
• Complaint – Term used to identify a dispute with the State, including appeal, charge, demand letter, and complaint.
• Claimant – Term used to denote party with a dispute with the State, including plaintiff, Claimant, complainant, and charging party.
• Disputed Wages – Term used to denote a settlement where a Claimant’s Complaint requests Wages but the settlement dollar amount is not payment of Claimant’s salary for a specific, articulated time period.  Disputed Wages do not trigger a PERA contribution or deduction.
• Exclusions from Income - IRC §104 is the exclusion from taxable income provision with respect to lawsuits, settlements, and awards.  This includes Personal Physical Injury, property damage, and wrongful death.
• Front Pay – Term used to denote payment for lost future compensation or in lieu of reinstatement.  Front pay does not trigger a PERA contribution or deduction.
• Income - IRC §61 states all income from whatever source derived is taxable, unless specifically excluded by another Code section.  Income can be either Wages or non-wages.
• Non-wage Income – Claims that do not include Wages as well as claims for interest and punitive damages.
• OAG – Office of the Attorney General.
• OSC – Office of the State Controller.
• Personal Physical Injury – Observable or documented bodily harm, such as bruising, cuts, swelling, or bleeding is evidence of Personal Physical Injury.
• Reinstatement –Claimant is put back into his/her position prior to the Complaint.
• Relinquishment of Tenure Rights – Faculty member resigns from their tenured position.
• SORM – State Office of Risk Management
• State Entity – Any executive branch agency or institution of higher education.
• Wages - IRC § 3401(a) defines Wages as all remuneration for services performed by an employee for his/her employer.  Generic term for Disputed Wages, Back Pay, Front Pay, or Relinquishment of Tenure Rights.
• Withholding - When the State pays Wages, the State withholds federal, state, and Medicare tax.  The State does not withhold these taxes when making payments that are not Wages.

Steps in the Settlement Process

• Step 1. Settlement Event. State Entity and/or SORM, OAG, and Claimant agree to a settlement process to resolve a dispute with the State. 
• Step 2. Determine the settlement amount and request settlement authority. State Entity shall inform the OAG attorney the amount the State Entity is willing to offer or authorize to the Claimant to settle the dispute.  Generally, the State Entity pays the settlement amount, except when a claim or lawsuit is governed by the Colorado Governmental Immunity Act or federal law.  In this case, Risk Management pays the settlement amount.
• Step 3.  Negotiate settlement and determine the settlement payment allocation.
  • 3a. Determine the reason for the settlement payment and who receives payment. Ask, “Why is the State making the settlement payment?”  Look to the Complaint to identify the reasons for the dispute. Who is being paid and for what reason?
  • 3b. Determine whether a portion of the payment is non-taxable.  Settlement payments for claims of Personal Physical Injuries or physical sickness, property damage, and wrongful death are not taxable.  CRS 24-10-114 (4) and (5) provide that a public entity shall not be liable directly or by indemnification for punitive or exemplary damages or for damages for outrageous conduct, except as otherwise determined by the state claims board.  Unless there is such a determination by the state claims board, settlement payments for claims of Personal Physical Injuries or physical sickness, property damage, and wrongful death shall be deemed to not include punitive or exemplary damages even if the Complaint alleges punitive or exemplary damages.
    • Personal Physical Injuries or physical sickness.  This portion is excluded from income.  To exclude this portion of the payment from income: 1) the underlying cause of action giving rise to the recovery must be based on tort or tort-type rights, and 2) the damages must have been received on account of a Personal Physical Injury or physical sickness.  Emotional distress shall not be treated as a Personal Physical Injury or physical sickness. The Complaint and the Settlement Agreement must use the wording “Personal Physical Injury” to be excludable from income. If there is a Personal Physical Injury and there are other causes of action included in the Complaint, under IRS revenue ruling, then the entire recovery is for Personal Physical Injuries excludable from gross income.
    • Property damages.  Payments for property damage are non-taxable to Claimant.
    • Wrongful death.  Claims for wrongful death usually include damages for physical and mental injury, as well as punitive damages for reckless, malicious, or reprehensible conduct.  A settlement payment attributed to physical or mental injury (including compensatory damages such as the decedent’s lost Wages) is non-taxable. If the state claims board determines that there are punitive damages, then the portion of the settlement payment for punitive damages is taxable.
    • Payments to the COBRA Administrator of the health insurance premiums for a separated employee is not taxable to the separated employee.
  • 3c. Determine whether the claim is taxable, but not Wages.  Review the Complaint to determine the nature of the claim.  If a Claimant is not claiming Wages, and the Claimant’s claim is taxable, then the payment is income to the Claimant, but not Wages.  In addition, punitive damages are taxable regardless of the nature of the claim, and interest is taxable. In these situations, the State issues a form 1099 upon payment to the Claimant. 

  • 3d. Determine whether the claim is for Wages.  If a Complaint includes a claim for Disputed Wages/Back Pay/Front Pay, then at least a portion of the settlement must be designated as some type of Wages. If there are claims other than the wage claim that are specifically negotiated and identified in the agreement, the payment will have to be apportioned between Wages and the non-wage payment.

    Where reinstatement is the only demand, the IRS considers the settlement payment to be front pay because the State is paying money instead of reinstating, so the IRS requires the State to treat that payment as Disputed Wages.

    If a settlement includes a resignation in lieu of termination, any amounts paid as part of this settlement are considered Disputed Wages.

  • 3e. If settling a claim for wages, determine type of Wages.
    • Disputed Wages.
      • If the settlement payment is for Wages, but is not for PERA Back Pay, then, the settlement agreement will include language that the payment represents Disputed Wages. This will not trigger PERA.   Disputed Wages includes settlements where reinstatement is the only demand, settlements that include resignation in lieu of termination, settlements for Front Pay, and settlements for the Relinquishment of Tenure Rights.
      • It is appropriate to use the “Disputed Wages” language even if the employee checked “Back Pay” as the requested relief on the State Personnel Board appeal form.  Using the IRS approach, all or part of the settlement payment will be for Wages because the claimant’s original claim included Back Pay. 
      • For Disputed Wages with current employees, the settlement agreement will include language that the State shall issue a form W-2 on payment.  For Disputed Wages with former employees, the settlement agreement will include language that the State shall issue a form 1099 on payment.
      • For Disputed Wages with current and former employees, the State Agency shall make the payments to current and former employees for Disputed Wages.  If the payments are funded by Risk Management, then Risk Management shall reimburse the State Agency for these payments. 
    • Front Pay. If the settlement payment is for Front Pay, the State entity will issue a form W-2 on the payment, and this will not trigger a PERA payment or contribution. 
    • Back Pay and PERA implications. 
      • PERA understands that sometimes the State is giving consideration for withdrawing a claim and that even if the State is issuing a form W-2, PERA deductions and contributions should not be made under all circumstances.
      • PERA should be part of the settlement only if the payment is Back Pay as defined by PERA.  To be Back Pay for PERA: 
        • The payment must be compensation for past services rendered.
        • The settlement, order, or award must outline the period of time for which it applies. There must be a definite time period for the Back Pay when the Claimant worked as an employee for the State and a calculated amount for the Back Pay for that period.  In that case, the settlement agreement should be clear that the payment is Back Pay and the settlement agreement shall include the beginning and ending dates for Back Pay and the amount due during this period. That will trigger a PERA deduction and require the employer to make its contribution and to withhold the employee’s contribution.
        • The payment amount cannot be greater than the rate of pay the member would have received had he or she been employed with the employer and/or paid at the time services were provided.
        • Examples of Back Pay for PERA:
          • A finding that the employee/former employee is entitled to an award of Back Pay.
          • Moving an employee’s separation date – her last day was December 15 but she resigned effective December 31, the period between December 16 and December 31 is Back Pay.
          • Giving a promotion, unpaid overtime or pay adjustment retroactively.
    • Relinquishment of Tenure Rights. If the settlement payment is for Relinquishment of Tenure Rights, the State entity will issue a form W-2 on the payment, and this will not trigger a PERA payment or contribution.  Payments made by educational institutions to tenured faculty in exchange for the Relinquishment of Tenure Rights constitute wages.  See Rev. Rul. 2004-110. 
    • Benefits. For either PERA Back Pay or Disputed Wages, in cases where the Claimant is no longer an employee, the State will not deduct medical, dental, vision, life insurance or any other elective benefit.  If the Claimant requests that the State pay a certain number of months for these benefits, then this amount could be included in the amount paid to the Claimant.  The State cannot retroactively provide benefits to the Claimant who is no longer an employee.  Such payments in cash to the Claimant as a proxy for benefits are taxable to the employee and the State shall issue a form 1099 for these payments. 
  • 3f. Attorney Fees.  Determine the portion of the payment that is for attorney’s fees.  The OAG attorney shall separately identify attorney fees in the agreement. The Claimant’s attorney will receive a form 1099 for the amount of attorney’s fees paid to the attorney and the Claimant will also receive a form 1099 for the amount of attorney’s fees.  If the claim is for non-wages, then the amount paid to the attorney is taxable to both the attorney and the Claimant as non-wage income.  If the settlement is for Wages, and the agreement clearly allocates a reasonable amount of the settlement payment as attorney’s fees, the amount allocated to attorney’s fees, while includable in income, is not wages for employment tax purposes.  The specific amount allocated as attorney’s fees should be paid directly to the attorney and not in a joint payment.  In rare cases where the settlement agreement does not clearly allocate an amount for attorney’s fees, and OAG attorney is unable to separately identify attorney fees and the claim is for Wages, then the entire amount paid to the Claimant is Wages for employment tax purposes.
  • 3g. Apportion settlement payment where settling multiple claims.
    • If the Claimant has multiple claims, then the State OAG attorney will apportion the payment amount.  The attorney will allocate the settlement in a way that is reasonable and based on the facts and circumstances of the case.
    • For employment cases, a key consideration is the amount that is for Wages vs. non-wages.  For tort cases, a key consideration is the amount that is taxable vs non-taxable.  If the Claimant has a Personal Physical Injury, which is non-taxable, and also claims punitive damages, then a portion of the settlement agreement allocated to settling the punitive damages claim will be taxable.
    • The OAG attorney will document the rationale for apportionment of the settlement agreement.
  • 3h. Determine Payees
    • Separate checks – With separate checks, there is greater clarity regarding the apportionment of the settlement amount and reporting of income. 
    • Joint check to Claimant and attorney – The OAG attorney will agree to a joint check to the Claimant and attorney only in non-wage settlements.  With a joint check, the payment will be reported to both the Claimant and the attorney as 1099 income, unless the settlement is for a tax-exempt claim, such as Personal Physical Injuries.  In such case, the payment will be reported to the attorney as 1099 income. To avoid potential issues with payroll, joint payees cannot be used when the settlement includes a claim for Wages.
  • 3i. Summary Table and Examples – see Appendix
• Step 4. Obtain form W-9s. Claimant and any other person or firm receiving a payment shall submit a form W-9. The OSC uses the form W-9 to ensure payment is made to an individual or firm with a valid SSN/EIN on file with the IRS.  The OSC also uses form W-9 to determine whether the Claimant, the attorney’s firm or other payee owes the State money. The OAG attorney should obtain a form W-9 from all Claimants and payees, including  an attorney payee, as soon as agreement is reached in principle. 

• Step 5. Draft the settlement payment paragraph and revise recitals. The settlement payment paragraph should read as applicable: 

  “SETTLEMENT PAYMENT.  The State Entity will provide [Claimant’s name] a payment in the amount of $[Dollar Amount] broken down as follows: [breakdown detail].  The State Entity will pay [Claimant’s name] the amount of $[Dollar Amount], which represents (reason for dispute - disputed wages, back pay, personal physical injury, etc.). 

  For wage settlements: “The State Entity will issue a form W-2 to Claimant’s name] on the payment. The State Entity will deduct from this portion of the payment all applicable state and federal withholding taxes, Medicare taxes, and other deductions required by law.”   
  Note that if the State Entity pays the Claimant an agreed amount that includes attorney fees, and the amount is not separately identified, the payment will be reported on the employee’s form W-2. 

  For taxable, non-wage settlements or the non-wage allocated portion of a wage claim: “The State Entity will pay to [Claimant’s name] $[Dollar Amount], which is made in compromise of [Claimant’s name]’s claims and is not designated as disputed wages, salary, or back pay or compromise of claims. The State Entity will issue a Form 1099 to [Claimant’s name] on this portion of the payment.” 

  For attorney’s fees: “The State Entity will also pay [Claimant’s name]’s counsel, [Law Firm LLP], the amount of $[Dollar Amount] and will issue a Form 1099 on this portion of the payment to the [Law Firm LLP] and will also issue a form 1099 to the Claimant on the payment.”  

  For non-taxable tort claims: Include the wording “personal physical injuries.”  Unless there is a determination by the state claims board as provided in CRS 24-10-114 (5), the Settlement Agreement shall include the wording, “None of the settlement payment is for punitive or exemplary damages as limited by CRS 24-10-114(4). 

  Recitals: OAG attorney will also revise recitals to include reason for the settlement payment.  “WHEREAS, the parties wish to avoid the expense and vagaries of litigation, and the parties are willing to settle their disputes related to [reason for dispute] on the terms set forth in the Release and Settlement Agreement without admissions of liability or wrongdoing…” 

• Step 6. Obtain State Controller pre-approval. As soon as a settlement has been achieved in principle, the OAG should send to the OSC: 
  • A draft of the settlement agreement with the understanding that the amount may change after the OSC determines if the Claimant, attorney or other payee owes the State money.
  • A copy of the Complaint.
  • Form W-9’s for the Claimant and any person receiving a payment.  The OSC will check for debts and report back to the OAG if any debts are identified and need to be intercepted.  The OAG will revise the draft settlement agreement with the appropriate intercept language in the payment provision.
  • Apportionment of the settlement payment (dollar amounts for each): o What portion is non-taxable.
    • What portion is taxable, not Wages and this portion of the payment to the employee, if any, would be appropriate for a 1099 (emotional distress, for example).
    • What portion is PERA Back Pay, Front Pay, or Disputed Wages, and why.  For PERA Back Pay, there will be a PERA deduction.
    • What portion represents attorney’s fees.
    • Statement that attorney’s fees are or are not reasonable and why.
• Step 7. Perform debt check - offset process. OSC checks with Central Collection Services, Judicial and CORE to determine whether the claimant, other payee or attorney payee owes the State money.  If the Claimant, attorney’s firm or other payee owes the State money, the OSC will notify the OAG attorney to advise the Claimant’s counsel of the amount of debt identified for the Claimant and other payees.  The State Entity shall deduct these amounts from the settlement payment in compliance with CRS 24-30-202.4 (3.5) (a). The OSC’s debt check process includes all Claimants and payees, including attorney payee(s). 
• Step 8. Special Situation - Section 111 of Medicare, Medicaid, and SCHIP Extension Act of 2007.
  • 8a. Medicaid, Medicare, Military and Veterans Medical facilities occasionally provide medical services to tort Claimants injured by the State.  If the settlement agreement does not reimburse the federal medical provider for the services provided to the Claimant, federal law imposes a lien and right of suit against the State for the federal government to recover the cost of the medical expenses for the Claimant.  Medicaid and Medicare are the predominate provider of such medical services to the Claimant.  To help insure the reimbursement of a federal medical provider, the OAG attorney needs to inquire of the Claimant and/or Claimant’s attorney whether any federal medical program provided services to the Claimant as a result of the injury sustained.
  • 8b. For tort actions; where liability for bodily injury has been determined, the OAG attorney shall coordinate with Claimant Attorney to determine whether Claimant is eligible for Medicare. The State Office of Risk Management (SORM) can provide the Medicare 111 Safe Harbor Letter and form to OAG. OAG will provide the Medicare 111 form to Claimant Attorney and request Claimant complete the form. If it is determined the Claimant is eligible for Medicare, Claimant Attorney should contact the Centers for Medicare and Medicaid Services (CMS) to request a conditional payment letter. The CMS letter provides the total expenses paid by CMS for medical services provided to the Claimant. The conditional payment letter will be provided to SORM to pay CMS directly.   If the Claimant’s attorney has not provided the conditional payment letter for Medicare the OAG attorney will work with SORM to resolve the Medicare medical services paid by CMS, 
  • 8c. The OAG attorney shall work with the OSC to inquire to the Colorado Department of Health Care Policy & Financing (CDHCPF) to determine whether there is a Medicaid lien. If there is a Medicaid lien, the OSC will direct that sufficient funds be deducted from the total settlement payment. The Medicaid Lien will be paid directly to CDHCPF by SORM.
  • 8d. If the Claimant is eligible for Medicare/Medicaid, the OAG attorney will add Medicare/Medicaid provisions to the settlement agreement.
• Step 9. Special Situation - Class Actions. A class action can be either an opt-out or opt-in case. 
  • In an opt-out case, no class member (other than perhaps a class representative) will generally execute a fee agreement with class counsel.  Potential class members generally do not need to take action and are generally not identified individually.  
  • In an opt-out class action, class members are typically not required to include any share of attorney’s fees in their gross incomes.  Members are taxed only on what they receive. •In an opt-in case, individuals have to affirmatively do something to become part of the case.  A plaintiff will not become part of the case and is bound by it unless he or she affirmatively elects to “opt in“ the case and its settlement.  In an opt-in case, class members are individually identified. 
  • In an opt-in case, each class member usually has gross income not only on the cash that the member receives, but also for his or her proportionate share of attorney’s fees.
  • In both an opt-out and opt-in cases, the State issues a form 1099 to the class members unless the dispute involves either Wages, in which case the State will issue a form W-2 to the class members/employees, situations that are non-taxable.
• Step 10. Circulate Settlement Agreement for Signatures. OAG attorney circulates the Settlement Agreement for signatures in the following order: 1) Claimant, 2) State Entity, 3) DPA Executive Director if applicable, and 4) OSC.
• Step 11. Prepare Settlement Agreement Cover Sheet for Payment. OSC prepares the cover sheet that includes how the payment will be paid, the amounts, tax reporting, and object codes for the paying State Entity to intercept and pay debts of the Claimant, attorney or any payee, and to prepare the checks to the Claimant, Claimant’s attorney and other payees.
• Step 12. Pay the settlement payment to Plaintiff/Claimant/Charging Party and attorney’s firm. The State Entity, following the cover sheet instructions, will make the payment to the Claimant, attorney’s firm, other payees and debt reporting agencies. Risk Management shall pay claims for cases involving Risk Management.  For other cases, usually the State Entity issues a check and the OAG attorney delivers the payment to Claimant or Claimant’s counsel.  Within the State Entity, the payroll unit will prepare a payroll check that is reported on form W-2 and the accounting unit will prepare a check that is reported on form 1099. The standard language in the settlement agreement provides that the State shall pay the Claimant, the attorney’s firm and other payees within 30 (thirty) days of the effective date of the Release and Settlement Agreement.

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