Taxing Lessons From Court Decisions

Decisions — The character of the payment

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Image source: Teodoraturovic (Own work) [CC BY-SA 4.0], via Wikimedia Commons
Image source: Teodoraturovic (Own work) [CC BY-SA 4.0], via Wikimedia Commons

Character makes the person. Character matters in the tax code too. For example, the character of an employment-related payment determines whether the payment is includable in gross income and whether it is wages for purposes of employment taxes. That determination in turn governs on which form the payment is reported.

In Chief Counsel Advice 2016-0026, the taxpayer wanted to know whether a “waiting time penalty” paid to an employee under California law should be reported on Form 1099-MISC, Miscellaneous Income, or Form W-2, Wage and Tax Statement.

The waiting time penalty is assessed under California law when an employer fails to pay, within the time period required by state law, the final wages of an employee who quits or is terminated. The penalty is based on the employee’s daily rate of pay and is calculated by multiplying the daily wage by the number of days the employee was not paid, up to a maximum of 30 days. California’s Labor Office website states the waiting time penalty is not wages and no deductions are taken from the penalty payment.

The taxpayer believed the penalty belonged on Form W-2, because treasury regulation 1.6041-2(a)(1) specifies that wages, as defined in internal revenue code section 3401, and other “compensation” paid by an employer to an employee in the course of the employer’s trade or business is reportable on Form W-2. The taxpayer said “other compensation” referred to in the regulation included any payment an employer made to an employee that is includible in the gross income of the employee and not specifically subject to reporting under another provision or form.

The IRS agreed the waiting time penalty was includible in the employee’s gross income, but asked whether the payment actually belonged on Form 1099-MISC.

Here are the relevant cites as to which form should be used.

Payments of rent, salaries, wages, compensation, or other fixed or determinable income are reportable under section 6041 of the internal revenue code. Generally, such payments are reported on a Form 1099 per regulation 1.6041-1(a)(2). However, the regulations provide instances where other forms should be used for reporting, such as for payments to beneficiaries of a trust or estate (reportable on Form 1041) and payments of compensation from an employer to an employee (reportable on Form W-2).

Regulation 1.6041-2(a)(1) specifies that wages, as defined in internal revenue code section 3401, and other “compensation” paid by an employer to an employee in the course of the employer’s trade or business shall be reportable on Form W-2.

 

ON WHICH FORM DO YOU THINK THE PAYMENT SHOULD BE REPORTED?

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THE DECISION

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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There is no dispute that, under the broad definition of gross income for federal income tax purposes, the waiting time penalty is includible in the gross income of the former employee who receives the payment. The waiting time penalty, although includible in gross income, appears to be in the nature of a penalty for the behavior of the employer that would not be wages for purposes of federal employment taxes.

Payments of rent, salaries, wages, compensation, or other fixed or determinable income are reportable under section 6041 of the internal revenue code. Generally, such payments are reported on a Form 1099 per regulation 1.6041-1(a)(2). However, the regulations provide instances where other forms should be used for reporting, such as for payments to beneficiaries of a trust or estate (reportable on Form 1041) and payments of compensation from an employer to an employee (reportable on Form W-2).

Regulation 1.6041-2(a)(1) specifies that wages, as defined in internal revenue code section 3401, and other “compensation” paid by an employer to an employee in the course of the employer’s trade or business shall be reportable on Form W-2.

As noted, the payments of the waiting time penalty are not wages. The payments also do not constitute compensation for purposes of the reporting requirements under the regulations. The Internal Revenue Service has consistently interpreted the undefined term “compensation” in section 1.6041-2 to include only payment for services, rather than to include all payments from an employer to an employee whatsoever. In this case, the payments are of a punitive nature, and do not compensate the employees for their services.

The waiting time penalty is not designed to compensate employees for work performed. Instead, it is intended to encourage employers to pay final wages on time, and to punish employers who fail to do so.

Payments to employees that constitute fixed or determinable income, but do not compensate them for services, are reported on Form 1099-MISC. For example, liquidated damages, judgments, and settlements that are income but do not constitute compensation are reportable as Other Income in box 3 of Form 1099-MISC.

Therefore, the payments are subject to reporting in box 3 of Form 1099-MISC, in the same manner as other non-compensatory liquidated damages, rather than on Form W-2. They are not reportable on Form W-2 because they are neither wages nor other “compensation” paid to an employee, within the meaning of regulation 1.6041-1(a)(2).

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