Payroll in Practice: 1.31.2022

Question: We are getting ready to pay a wage settlement to a former employee. The payment will be made through the former employee’s attorney. Do we report this on Form 1099 or Form W-2?

Answer: The award is a wage payment even though it is paid to a lawyer and is made on behalf of a former employee. Generally, the employer computes income tax withholding based on the employee’s last valid Form W-4, Employee’s Withholding Certificate, and the regular pay period used for the employee during the time of employment.

The employer should check with its legal counsel to ensure that all parties understand the employer’s withholding obligation.

For income tax withholding purposes, the payment amount is supplemental pay. The employer may use the optional flat-rate method of withholding only if income tax was withheld from the employee’s regular pay during the calendar year of payment or the immediately preceding calendar year. Otherwise, the optional flat rate may not be used.

The requisite withholding that would allow use of the optional flat rate may not have occurred if the last regular pay the employee received from the employer was paid prior to the preceding year. It also would not have occurred if the employee was only paid supplemental wages during the current and preceding calendar years. An example of this is commission-only compensation.

That means, for a wage settlement payment made in 2022, the optional flat rate may not be used if the employee received no regular wages from the employer after Dec. 31, 2020, even if taxes were withheld from supplemental pay such as commissions or severance pay.

A Form W-2 for the current year should be issued to the employee showing the gross pay and the amounts withheld. In addition, a Form 1099-MISC should be issued to the payee’s lawyer with the amount paid to the lawyer reported in Box 10. Note that these amounts can overlap.

For example, an employer reaches a wage settlement with a former employee for $300,000. The employer withholds $100,000 for state and federal income tax and Social Security and Medicare taxes.

The remaining $200,000 is paid to the former employee’s attorney. The attorney deducts $60,000 in attorney fees and pays the remaining $140,000 to the former employee.

The employer issues a Form W-2 to the former employee reporting $300,000 in wages and $100,000 in withheld taxes. The employer also issues a Form 1099-MISC to the attorney reporting $200,000 in Box 10.

If this is pay for a prior year and is statutory back pay, a report may have to be filed with the Social Security Administration that shows the periods and amounts related to the back pay. Statutory back pay is an award, determination, or agreement approved or sanctioned by a court or government agency responsible for enforcing a federal or state statute that protects an employee’s right to employment or wages.

For statutory back pay information and details for preparing and submitting the report, see IRS Publication 957, Reporting Back Pay and Special Wage Payments to the Social Security Administration.

Employers may also find it necessary to determine whether the entire award constitutes wages or if any of the payment is for something other than wages. For example, punitive damages are generally reportable to the payee on Form 1099-MISC in Box 3.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., or its owners.

Author Information

Patrick Haggerty is the owner of a tax practice in Chapel Hill, N.C., and an enrolled agent licensed to practice before the Internal Revenue Service. The author may be contacted at phaggerty@prodigy.net.

Do you have a question for Payroll in Practice? Send it to phaggerty@prodigy.net.