Academic journal article Journal of Accountancy

"Wages" and the Employer-Employee Relationship: A Change in IRS Position on Withholding

Academic journal article Journal of Accountancy

"Wages" and the Employer-Employee Relationship: A Change in IRS Position on Withholding

Article excerpt

In revenue ruling 2004-110, the IRS effectively reversed its position on cancellation payments in the context of an employer-employee relationship, concluding that amounts paid to an employee as consideration for the cancellation of an employment contract and relinquishment of contract rights were wages subject to Social Security, Medicare, and federal unemployment and income tax withholding. CPAs should be aware of this IRS change in position.

THE FACTS

In the ruling, an employee was to perform services under a written contract for a set number of years. The parties cancelled the contract before the end of the agreed-on period; the employer paid the employee for relinquishment of his rights for the remaining period.

IRS's LOGIC

In holding that the contract cancellation payment constituted wages subject to withholding, the IRS reasoned that the employment relationship encompasses the establishment, maintenance, furtherance, alteration or cancellation of said relationship. For an employer's payment not to be treated as wages, the employee would have to provide clear, separate and adequate consideration for the payment that did not depend on the employee-employer relationship. Further, the IRS deemed the payment taxable ordinary income to the employee, not capital gain.

The ruling did not address the employment tax treatment of liquidated damages paid by an employer to an employee as part of a settlement (traditionally treated as nonwage payments). In revenue ruling 72-268, certain payments representing liquidated damages made by an employer to its employees were neither remuneration for employment nor wages for federal employment tax purposes (including income tax withholding). …

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