April 15, 2010 is not far away and as most folks know that is the deadline for filing your federal income tax return. I have been busy lately dealing with a number of tax issues affecting my employment clients. One issue in particular is worth mentioning.

First, as an initial matter, monies received in the settlement of an employment case are almost always taxable. The exception is monies that can be said to have been paid on account of personal injuries. These monies are not taxable. See 26 U.S.C. 104(a)(2). Click here. Accordingly, unless monies are paid to the client on account of personal injuries, the monies received will be subject to income tax.

When one of my employment clients settles a case and receives money in exchange for dismissing the case, a portion of the money is generally allocated as payment of back wages and a portion of the money is generally allocated as compensatory damages or liquidated damages. When money paid to the client represents back wages, a Form W-2 is issued by the company to my client. When money paid to the client represents compensatory or liquidated damages, a Form 1099 is issued by the company to my client.

Often, the Form 1099 issued to my clients is incorrectly completed by the company. Form 1099-misc. By this I mean that Box 7 “nonemployee compensation” on the Form 1099 is checked, rather than Box 3 “other income”, which is the correct box that should be checked on Form 1099 for payments of compensatory damages or liquidated damages. Box 7 is for payments made to independent contractors.

The impact of Box 7 being checked is that the client is erroneously subjected to the self-employment tax. Click here. Accordingly, to avoid this negative consequence I try to include language in all settlements agreements that Box 3 “other income” should be checked when monies are being paid as compensatory damages or liquidated damages.