Payroll in Practice: 2.24.2025

Question: A company reached a wage settlement with a former employee. The settlement amount covers back wages and interest. The company is instructed to pay the settlement proceeds through the attorney representing the former employee. What are the tax and reporting requirements?

Answer: The award is a wage payment even though it is paid to an attorney 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. Or, the employee may submit another Form W-4 for the settlement. The employer should check with its legal counsel to ensure that all parties understand the employer’s withholding obligation.

For income tax withholding purposes, a back pay award is a supplemental wage payment. There are three supplemental wage withholding methods: the mandatory flat-rate method, the aggregate method, and the optional flat-rate method.

The mandatory flat rate is the maximum individual income tax rate in effect for the year of payment, which currently is 37%. This rate applies to cumulative supplemental payments paid to the employee during the calendar year over $1 million, including any portion of a payment that causes the cumulative amount to exceed $1 million.

The aggregate and flat rate methods may not be used to compute withholding for any amount to which the mandatory flat rate applies, though they may be used for amounts below the $1 million threshold.

The aggregate method computes withholding on total taxable wages, excluding any amount subject to the mandatory flat rate. It is based on the Form W-4 currently in effect for the employee, the appropriate pay period, and the percentage or wage bracket tax tables. The optional flat-rate method applies a flat 22% rate to the gross supplemental wage for the pay period, also excluding any amount to which the mandatory flat rate applies.

The employer may use the optional flat-rate method only if it withheld income tax from the employee’s regular pay during the calendar year of payment or the immediately preceding calendar year. For example, for a settlement paid in 2025, an employer may not calculate withholding using the optional flat rate if its last wage payment to the employee occurred before 2024.

Additionally, the optional flat rate is also not allowed if the only compensation the employee received during the current and preceding calendar years was supplemental wages, such as commissions or severance pay.

Because the settlement is paid to the attorney, the employer must issue information returns to both the employee and the attorney.

For example, consider a wage settlement that provides an award of $300,000 in back pay plus $5,000 interest for a former employee. The employer withholds $100,000 in taxes and pays the remaining $205,000 to the attorney. The attorney retains a $60,000 contingency fee and pays the remaining $145,000 to the former employee.

The employer issues the former employee both a Form W-2, Wage and Tax Statement, and a Form 1099-INT, Interest Income. The Form W-2 is used to report the $300,000 in back wages and the $100,000 in withheld taxes. The Form 1099-INT is used to report the $5,000 in interest. Note that the contingency fee is taxable income to the employee.

The employer issues the attorney a Form 1099-MISC, Miscellaneous Information, reporting $205,000 in Box 10, “Gross proceeds paid to an attorney.” This is not duplicate reporting. The Internal Revenue Service recognizes that amounts reported in Box 10 are not necessarily income for the attorney.

The employer is also responsible for paying other applicable employment taxes, such as its share of Social Security and Medicare, federal unemployment taxes, and any applicable state taxes.

Payments of statutory back pay for prior years have special rules. The employer may need to file a report with the Social Security Administration that shows the periods and amounts related to the back pay. For more information and details on preparing and submitting the report, see IRS Publication 957, Reporting Back Pay and Special Wage Payments to the Social Security Administration. The publication defines statutory back pay as “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.”

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 in Box 3 of Form 1099-MISC as other income.

This column does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., or its owners.

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

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