Drafting agreements, including employment, severance and settlement agreements, which properly protect the company’s interests and achieve the intended results is just one of the myriad tasks that general counsel must perform expertly. The long-awaited final regulations issued by the IRS on section 409A of the Internal Revenue Code have significantly complicated the making and breaking of employment agreements. In addition, settling employment claims also raises a number of compliance issues, including the proper reporting, withholding and taxation of the settlement proceeds in order to avoid potential tax liabilities for the company. While consultation with an outside tax specialist on particular issues may be required, a general counsel’s awareness of these issues is crucial to avoiding potentially costly errors.

Deferred Compensation Issues Must Be Considered When Drafting Employment Agreements

Severance Pay and Benefits

When negotiating employment agreements or other arrangements providing separation pay, the parties must evaluate whether the severance pay and other-related severance benefits will be subject to the deferred compensation requirements of Section 409A of the Internal Revenue Code (“IRC”). IRC Section 409A, added by the American Jobs Creation Act of 2004, expands the definition of deferred compensation to include severance pay arrangements. If the severance arrangement qualifies as deferred compensation and does not comply with the strict payment requirements of Section 409A (including a six-month delay for severance payments made to “specified employees” of public companies), the amount of severance payments will be immediately included in the employee’s gross income (unless subject to a substantial risk of forfeiture), and will result in an additional 20% income tax penalty and interest charges being assessed to the employee.

409A Exemptions

Two exemptions from Section 409A are available for severance benefits that should apply to the vast majority of severance arrangements offered by employers. These exemptions will be helpful to structure severance benefits to give “specified employees”1 substantial benefits during the six-month period following termination of employment. Otherwise, the severance payments may need to be restructured to comply with the Section 409A payment rules.

  1. Short-Term Deferral Exemption. Severance pay that is payable only upon an involuntary termination of employment will be exempt from Section 409A if paid out in a lump sum immediately following termination of employment or paid in full within 2-1/2 months following the end of the year in which the involuntary termination occurred.

Certain “good reason” resignations will be treated as involuntary terminations (discussed below), and severance payable as a result of such “good reason” termination may be exempt under the Short-Term Deferral Exemption.

  1. Two-Times Exemption. Severance that is paid solely upon an involuntary termination (including certain “good reason” resignations) or under a window program not to exceed 12 months will be exempt from Section 409A, if (a) the amount of the severance does not exceed two times the lesser of (i) the employee’s annual compensation for the preceding year or (ii) $225,000 (for 2007), and (b) all payments are made to the employee no later than December 31 of the second calendar year following the year of termination.

Even if the total amount of the severance exceeds the specific dollar cap or extends beyond the permitted time period, the Two-Times Exemption will apply to exempt severance payments up to the amounts that fit within the exemption.

“Good Reason” Termination

A “good reason” termination, on the part of the employee, may be treated as an involuntary termination, and may qualify any severance benefits paid upon a “good reason” termination for the Two-Times Exemption or the Short-Term Deferral Exemption, if the termination is the result of actions taken by the employer that result in a material negative change in the employee’s relationship with the employer, such as a material negative change in the duties to be performed, the working conditions or the compensation paid for performing such duties. To qualify under a Section 409A safe harbor, the separation from service must occur within a limited period of time not to exceed two years from the initial event giving rise to the “good reason” condition and the good reason termination payments must be made in the same amount, at the same time and in the same form as payments upon an employer-initiated termination. In addition, the employee must provide the employer with notice of the “good reason” condition within 90 days of the initial existence of the condition and the employer must be given at least 30 days to cure.

Illustrative Examples

The following fact pattern will help to illustrate how the terms of an employment or severance agreement can greatly impact on the tax treatment of the severance pay:

ABC Company’s employment agreement with an Executive provides for severance equal to two-times her salary plus bonus upon involuntary termination and termination by the Executive for good reason. The Executive is not entitled to any severance benefit if she voluntarily resigns, other than for good reason. ABC Company terminates the Executive, without cause, on September 15, 2007. At the time of her termination, the Executive is entitled to severance in the amount $2,000,000. The Executive is a specified employee of a publicly traded company.

Variations in the timing of the severance payment(s), and the definition of good reason in the agreement, significantly impact the tax treatment of the severance pay, as follows:

  • If the employment agreement requires the severance payment to be made in a lump sum within 30 days following termination of employment, and the good reason termination definition in the employment agreement does not satisfy the Section 409A safe harbor, no amounts may be paid to the Executive prior to six months following termination of her employment. This severance payment cannot take advantage of either the Short-Term Deferral Exemption or Two-Times Exemption because it is not paid solely on account of an involuntary termination of employment.
  • If the employment agreement requires the severance payment to be made in a lump sum within 30 days following termination of employment and the good reason termination definition falls within the Section 409A safe harbor, the entire severance payment is exempt from Section 409A under the Short-Term Deferral Exemption.
  • Assume for the third scenario that the employment agreement provides that the severance will be paid over three years, in monthly installments of $55,556, beginning on the first day of the month following termination of employment. In addition, the good reason termination definition falls within the Section 409A safe harbor. In these circumstances, although the total severance payment exceeds the permitted limits for the Two-Times Exemption, the first six months of payments ($333,336) are exempt from Section 409A because such amounts do not exceed $450,000. These payments can be paid to the Executive in accordance with the monthly installment schedule, without the 6-month delay. Moreover, as structured, all severance payments subject to Section 409A will be paid after the first six months following termination of employment.

Continued Medical Benefits, Reimbursements and Tax Gross-Ups

Continued participation in the employer’s insured health plan after termination of employment is not a benefit subject to Section 409A, even if the employer pays the entire premium for the health coverage and the continued participation extends past the COBRA period. Reimbursement of outplacement expenses, actual moving expenses and deductible business expenses are also exempt from Section 409A to the extent the expenses are incurred by the end of the second year following the year of the employee’s termination of employment. Reimbursements must be made no later than the third year following the termination of employment. Tax gross-up payments (for example, the employer’s payment of the “golden parachute” 280G excise tax) are treated as deferred compensation, but will satisfy Section 409A if the employment or severance agreement provides that the tax gross-up payment will be made by the end of the employee’s taxable year following the year in which the employee remits the related taxes.

What Employers Need to Do Now

Employers should review all employment agreements, severance plans and other arrangements that provide severance benefits. Any employment agreement, severance plan or other arrangement not in compliance with Section 409A by January 1, 2008 could possibly subject the employee to the 20% penalty tax.

Any amendments to comply with theexemptions, conform a “good reason” termination definition to the Section 409A safe harbor, or impose the six-month delay on payments to specified employees following termination of employment must be made by December 31, 2007.

Settling Employment Related Claims Has Tax Implications

Assuming that the employer has successfully navigated the 409A issues related to severance pay, the possibility remains that an employee may file a discrimination or wrongful termination claim. Settlements or judgments on employment claims raise additional tax issues that must be considered. Because of the nature of employment claims, and the variety of damages sought, employers must be aware that all settlement proceeds are not treated equally for taxation purposes. Standard damages sought in employment related claims include back wages, front pay, damages attributable to emotional distress, punitive damages and attorneys’ fees. Depending on the claims and the basis for the settlement, the tax treatment (including reporting, withholding and tax payments due by the employer and employee) for a particular settlement payment can vary greatly.

Settlement Proceeds Must Be Accurately Allocated

Employers are responsible for withholding state and federal income, Social Security and Medicare taxes from their employee’s paychecks. In addition, employers must report and pay taxes under the Federal Unemployment Tax Act. Similarly, employment tax payment and withholding responsibilities extend to payments of certain settlement proceeds which are taxable as wages. Moreover, emotional distress, punitive damages and attorneys’ fee awards are often reportable (and taxable) as income. Therefore, when an employer settles an employment related claim, a reasonable allocation should be made in the settlement agreement concerning the amounts of the settlement proceeds which are attributable to lost wages, emotional distress, punitive damages (if any) and attorneys’ fees. If the parties make no allocation, the IRS will allocate a lump sum settlement itself based on the evidence it can gather, and will tax it according to its allocation. In some jurisdictions, the lump sum settlement will be assumed to be 100% wages for tax purposes, which is ordinarily not the case, and is a harmful result for both the employer and employee.

Unfortunately, there is no precise formula which employers can follow to properly allocate, report and pay taxes on settlement payments. As a general rule, the allocation should be made by applying the “origin of the claim rule,” which is based on the facts and circumstances of the claims made in a particular case. Factors which should be considered in determining how settlement payments should be allocated include the allegations in the complaint (or the charge of discrimination in an administrative proceeding before the EEOC or state human rights agency); the evidence presented at trial or gathered in discovery; the details surrounding the litigation, including the arguments (and the strength thereof) made by each party and the time spent by the parties advancing or defending each claim; and the motivation of the employer for settling the claims (i.e. what claims does the employer understand that it is settling). It is important to note, however, that the IRS is not bound by the parties’ allocations, particularly where the allocated settlement payments do not accurately reflect the underlying claims and their respective value. In numerous cases, the IRS has reallocated a settlement or award (and the taxes to be paid on the award), and the courts have upheld the Service’s reallocation.

Back Pay and Front Pay

Most state and federal statutes prohibiting employment discrimination on the basis of a variety of protected classes (race, sex, disability, etc.) specifically provide for the award of back pay to employees who have suffered a loss of wages as result of a discriminatory act. Similarly, wrongful termination claims often will result in the payment of back pay. The IRS treats back pay settlements and awards (not attributable to a physical injury or sickness2), severance pay, dismissal pay, or other pay for involuntary termination of employment as wages. Although there is division in the circuit courts, the IRS also takes the position that front pay and payments made in lieu of employee benefits also constitute wages. Therefore, when making a settlement payment (or judgment) to compensate a plaintiff for lost wages (whether or not the employee is employed at the time of the payment), employers should report that portion of the settlement or judgment on a W-2 form, and make all applicable state and federal employment tax withholdings and payments due on that portion of the settlement or judgment.

Emotional Distress Damages

Many plaintiffs (and their counsel) are under the misimpression that emotional distress damages are not taxable, and therefore push for a large percentage of the settlement proceeds to be allocated to emotional distress damages. However, doing so exposes both the employer and employee to potential tax liability. First, if settlement proceeds are misallocated as emotional distress damages, when they are actually compensation for back pay, both the employee and employer will have underreported (and underpaid) taxes owed on the settlement. Moreover, IRC Section 61 states that all income from whatever source derived is taxable, unless excluded by another section of the IRC. Section 104(a)(2), which excludes compensatory damages received “on account of personal physical injuries or physical sickness” from the definition of taxable gross income, was last amended in 1996 to expressly state that “emotional distress shall not be treated as a physical injury or physical sickness” for purposes of this exclusion. Therefore, the IRS and many courts interpreting the IRC have taken the position that a settlement payment (or judgment) for the intangible value of an emotional distress claim (i.e. claims unrelated to a physical injury or physical sickness) is taxable income. However, this amount is not subject to employment taxes and withholdings applicable to wages.

There is one statutory exception to this general rule. Pursuant to Section 104(a)(2), any amounts related to actual out-of-pocket medical costs the employee incurred for the treatment of emotional distress, which were not previously deducted by the employee, are excluded from gross income, and need not be reported. Therefore, when settling an employment claim, the settlement agreement should specifically allocate the amounts paid for intangible emotional distress damages and medical costs incurred by the plaintiff for the treatment of emotional distress. Any amount which exceeds the plaintiff’s actual medical costs (not previously deducted) is considered taxable income, which should be reported on a Form 1099.

Punitive Damages

Punitive damages, which are designed to punish wrongful acts, are considered a windfall to the plaintiff because they do not compensate the claimant for lost wages or pain and suffering. As such, the IRS treats punitive damages as taxable income – regardless of the nature of the underlying claim – because they are not “received on account of” physical injuries or sickness. Therefore, the employer should report punitive damages paid to an employee on a Form 1099, and the employee is responsible for paying the taxes due.

Attorneys’ Fees

The general rule is that when a claimant receives a settlement or award which qualifies as income, the amount which is allocated to the recovery of attorneys’ fees (even if paid directly to the attorney as a contingent fee) constitutes taxable income to the plaintiff, and should be reported on a Form 1099. Moreover, if the settlement check is made out to the plaintiff and his or her counsel jointly, a separate Form 1099 for the amount of the attorneys’ fees should be issued to the attorney (if the fees exceed $600). However, it is important to note that applicable state law may alter this general rule, and should be consulted.

In addition, depending on the circumstances of the claims and the settlement, the recovery of attorneys’ fees may also constitute wages. The general rule is that attorneys’ fees are allocated among the settled claims and treated as wage or non-wage income in accordance with that allocation. In cases where the plaintiff’s claim is based on a fee shifting statute (i.e. the ADEA), the amounts allocated to attorneys’ fees are not wages for employment tax purposes.

Indemnification Agreements

While the appropriate allocation of settlement proceeds and the proper reporting, withholding and payment of taxes associated with the settlement of employment claims will go a long way toward insulating the company from tax liability, settlement agreements should also contain indemnification language that makes the employee solely responsible for the payment of all tax liabilities imposed by the IRS or state taxing authority (including penalties, fines, interest, costs, expenses and attorneys’ fees) associated with the settlement payment.


Making and breaking employment agreements and settling employment claims implicate serious tax consequences that must be considered in order to properly protect a company’s interests. Recognizing these issues and consulting with tax specialists as needed, especially in light of the newly issued final regulations on IRC section 409A, is increasingly important for corporate counsel charged with handling employment and human resources issues. Being proactive is crucial to keeping up with the ever-evolving tax code and regulations so that the company’s practices, procedures and employment agreements do not create unnecessary corporate liability.