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Tax Issues in Employment Mediations
It is 9 p.m. After 12 brutal hours of mediation, the parties have finally reached an agreement. The former employee who had claimed wrongful termination will receive $100,000 in exchange for dismissing his lawsuit and executing a general release in favor of his former employer. Everyone is fatigued: The lawyer for the terminated employee has fought all day to persuade the mediator and the employer to pay a decent sum and he has finally succeeded. The lawyer for the employer has worked just as hard to keep the settlement amount within a reasonable range and has persuaded his client to pay it. The mediator is exhausted but elated that the parties have finally agreed to a number. All three now want to prepare a quick and simple term sheet to memorialize the settlement and leave the heavy drafting for another time. The last thing anyone wants to think about is taxes.
There is surely nothing wrong with preparing a term sheet instead of a formal agreement at the end of mediation. However, it can be a huge mistake to ignore tax issues. None of the lawyers needs to be a tax expert as long as they keep a few key issues in mind, including: 1) Are all the payments wages subject to withholding? 2) If some portion of the payment is non-wages, what is the allocation between wages and non-wages?
How will tax forms such as 1099 or W-2 be handled by the employer the following January? In the case of an employee who earns benefits other than straight salary, the parties must also consider whether any equity or stock option compensation will be paid as part of the settlement and, if so, whether it should be taxed as equity rather than ordinary income. Furthermore, if the plaintiff claimed physical injury or illness, some of the settlement may be treated as tax-free damages ' though this can be a red herring. Damages for plain old emotional distress ' including its physical consequences such as headaches and stomachaches ' are fully taxable.
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