The opinion adopts well-established federal law and overturns a 22-year-old California case that held that withholding was not required.

Everyone knows that, when an employer pays wages to an employee, the employer must withhold federal and state income taxes and social security (FICA). But what happens when a terminated employee receives an amount from the employer as a result of a lawsuit involving wrongful termination or discrimination? Does it matter if the lawsuit involves back pay or front pay? Is there a difference if the payment is the result of a settlement or a judgment? What if state law clashes with federal law?

These questions have been fairly well settled under federal law for a number of years, and withholding is required. However, California only recently adopted the federal law inCifuentes v. Costco Wholesale Corp.1 There, the Court of Appeals of California overturned the lower court and declined to follow a 22-year-old California case that had held that withholding was not required.

In Cifuentes, a dispute between Costco and its former employee Carlos Cifuentes resulted in a judgment in favor of Cifuentes after a jury trial. The dispute stemmed from Cifuentes’ report to his supervisor that he observed a manager hugging a female employee. Six months later, the manager reported that he saw Cifuentes sipping a beverage sold by Costco without paying for it. Costco fired Cifuentes for violating its policy against food consumption. Cifuentes sued for wrongful termination/breach of contract.

At trial, the jury awarded him $28,125 for past wages and $273,253 for future wage loss. When Costco paid the judgment, it withheld $116,150.84 in payroll taxes from the $301,378 attributed to lost wages. Costco informed Cifuentes that it had fully satisfied the judgment and demanded that Cifuentes acknowledge full satisfaction. Cifuentes disputed the withholding, claiming that Costco should have paid him the full judgment amount, issued Form 1099, and allowed him to pay any taxes due directly to the taxing authorities. The amount in controversy was reduced when Cifuentes received tax refunds from the Internal Revenue Service (IRS) and from California. At that point, Costco again demanded that Cifuentes acknowledge satisfaction of the judgment, which Cifuentes refused to do. Costco then asked the court for an acknowledgement of the satisfaction of judgment.

Cifuentes based his position on Lisec v. United Airlines, Inc.,2 which held that an employer is not required to withhold payroll taxes from an award of lost wages to a former employee. Believing that it was bound by Lisec, the trial court ruled that the withholding was improper and denied Costco’s motion for acknowledgment of satisfaction of the judgment. On appeal, the California Court of Appeals overturned the trial court. It ruled in Costco’s favor that lost past wages and lost future wages are subject to withholding, in effect overruling Lisec.

In support of Costco’s argument that the payments to Cifuentes were wages on which it had to withhold, Costco alleged that a failure to withhold could mean that it would have to pay twice by paying the judgment and also paying the taxes. The appeals court agreed, noting that an employer that fails to withhold taxes from an award of back or front pay to a former employee exposes itself to penalties and personal liability for those taxes. Therefore, the court declined to follow Lisec and instead adopted the prevailing federal law requiring withholding.

When Lisec was decided in 1992, there was limited law on the scope of "wages" for tax purposes. The plaintiffs in Lisec had prevailed on a wrongful termination claim and obtained an award of back and front pay. Their former employer withheld payroll taxes, claiming that the award constituted wages under federal and state law. When the plaintiffs asserted that the judgment was not satisfied, the employer moved for an acknowledgment of satisfaction of judgment. The trial court in Lisec denied the motion, finding that the employer lacked the authority to unilaterally reduce the judgment by withholding taxes. In affirming the decision, the court of appeals distinguished the case on the basis that the employees had not been reinstated. According to the court, as a result of failing to be reinstated, the award did not constitute remuneration for services performed and, therefore, was not wages for purpose of withholding.

The court of appeals in Cifuentes observed that, in the years since Lisec, numerous federal courts have considered whether back or front pay to a non-reinstated employee is subject to income and FICA taxation and withholding. The IRS view of wages is expansive, as is the view of the courts. In Revenue Ruling 72-572,3 the IRS stated that remuneration for employment constitutes wages, even though the individual is no longer an employee at the time of payment. The IRS’ position is that judgment and settlement payments for front and back pay (other than lost wages on account of personal injury or sickness) are subject to income and FICA tax withholding and are reportable as wages on a Form W-2, rather than as non-wage income on a Form 1099-MISC.4 With the exception of the U.S. Court of Appeals for the Fifth Circuit in Dotson v. United States,5 federal courts have adopted the broad definition of wages established in Social Security Board v. Nierotko.6 There, the U.S. Supreme Court held that an award of back pay to a wrongfully terminated employee constitutes wages for social security purposes. The Court rejected the argument that the award did not qualify as wages because no services had been performed and held that the term "service performed by an employee" means not only work actually done, but the entire employer-employee relationship for which compensation is paid. In Gerbec v. United States,7 for example, the U.S. Court of Appeals for the Sixth Circuit concluded that a portion of a settlement award of back and front pay in a class action brought by former employees against Continental Can Company was subject to both income and FICA taxes.8

Cifuentes contended that these cases were distinguishable from his case because they involved a settlement of claims, rather than a judgment. However, he could cite no case law suggesting that an award of back or front pay should be treated differently for tax purposes because it arose from a judgment rather than a settlement.

The Cifuentes court noted that, when Costco paid the judgment, it had two alternatives. It could follow Lisec and risk liability to the IRS and other taxing authorities for the amount of tax it failed to withhold plus penalties. Alternatively, it could follow the prevailing federal view by withholding and risk a judicial declaration that that judgment was not satisfied. Costco chose the latter course, and the court concluded that it chose correctly. Costco therefore had paid Cifuentes the full amount of the judgment.

Cifuentes did not demonstrate that his award of lost wages was exempt from income and FICA or that he was entitled to reimbursement of these taxes. His own financial expert testified that his award would be subject to FICA and state disability withholding. The appeals court agreed with Costco that, if the courts do not consistently apply the definition of "wages" for taxation and withholding purposes, employers and employees will have a difficult time understanding when payroll taxes must be withheld from judgments and settlements. The court noted that, by adopting the prevailing federal view, it ensures that California employers that withhold taxes from awards of lost wages are not subject to penalties. The court further pointed out that plaintiff employees have a remedy from over-withholding in the form of a refund from the taxing authorities.

Pepper Takeaways

In any employment tax dispute, employers should consider the amount subject to payroll tax withholding. In a settlement, this subject should be negotiated before a settlement figure is reached to avoid disputes about whether the settlement amount was net of withholding. The parties’ agreement should be documented in a settlement agreement. It may be appropriate to allocate some portion of the settlement to non-wage categories, e.g., pain and suffering or attorneys’ fees, in which case that amount of the settlement will be reported on Form 1099 and will not be subject to withholding. Withholding is required whether the payment is received as a result of a settlement or as a judgment. If there is a misunderstanding about withholding, the parties may need to go to court again to wrangle over withholding tax, which certainly should be avoided.