Union settlement payments treated as wages with limited payroll tax exceptions

Plain-English summary

A union asked how to tax and report settlement payments to city employees for wage increases the city had not paid under a collective bargaining agreement. The IRS treated the distributions as back pay and therefore as wages subject to federal income tax withholding. Social Security tax did not apply if a recipient qualified as a member of the city's retirement system for the relevant service, while Medicare tax applied unless the continuing-employment exception covered that employee. FUTA tax did not apply because the underlying services were performed for a city. The union was required to report the payments on Form W-2.

Ruling snapshot

• Question: Which federal withholding, Social Security, Medicare, FUTA, and reporting rules applied to the union's settlement distributions?
• Outcome: Mixed. The payments were wages for income tax and generally Medicare purposes, but retirement-system and governmental-service exceptions could remove Social Security and FUTA taxes.
• Key authorities: IRC §§ 3101, 3111, 3121, 3301, 3306, 3401, 3402, and 6051.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201643009 Third Party Communication: None
Release Date: 10/21/2016 Date of Communication: Not Applicable
Index Number: 3401.01-00
Person To Contact:
------------------------------------------------------- ----------------------, ID No. --------------
---------------------------------- Telephone Number:
--------------------------------------- ----------------------
Refer Reply To:
CC:TEGE:EOEG:ET2
PLR-115737-16
Date:
July 21, 2016

              TY:-------

Legend

Union = ------------------------------------------------------------

City = ----------------------------
State = ----------------------------
Retirement Plan = --------------------------------------------------------------------------------------------

x = --------------
year c = -------

Dear --------------------:

This is in reply to your request for a ruling concerning (1) whether settlement
distributions made under a settlement agreement by the Union to employees of the City
are “wages” subject to social security tax, Medicare tax, income tax withholding, and
Federal Unemployment Tax Act (FUTA) tax; and (2) how these settlement distributions
are reported for federal tax purposes.

The Union is a nonprofit corporation under State law that has been recognized by the
Internal Revenue Service (IRS) as an organization exempt under section 501(a) of the
Internal Revenue Code (Code) as an organization described in section 501(c)(5). Its
members are all employees of the City.

The City recognizes the Union as the sole bargaining agent for its member employees
of the City. The City and the Union have entered into collective bargaining agreements
(CBAs) which in part define the conditions of employment, including compensation.
PLR-115737-16 2

The City and the Union entered into a CBA that provided for wage increases. Because
of an alleged budget shortfall, the City did not implement the wage increases for one of
the fiscal years (year c) covered by the CBA.

The Union sued the City for breach of the CBA. After the case had been litigated and
was in an appellate stage, the Union and the City reached a settlement, under which the
City agreed to make a lump sum payment to the Union of x dollars in full settlement of
the Union’s claims. Under the settlement agreement, the Union is responsible for
distributing the payments (the “settlement distributions”) to its member City employees.
The settlement agreement provides that the Union is responsible for the determination
of the employees that are eligible for a settlement distribution and for the determination
of the exact amount of the settlement distribution to be paid to each employee. The
settlement agreement provides that those member employees who were employed by
the City during fiscal year c are entitled to a settlement distribution. Those employees
will receive the same distribution amount regardless of position or tenure, provided,
however, that those employees who were employed for only a portion of the fiscal year
c will receive a pro rata share. The Union must issue each affected employee a
separate check.

The settlement agreement also requires the Union to indemnify the City for any claims
raised by the employees regarding the settlement agreement or the settlement
distributions. The agreement provides that the Union acknowledges that it is
responsible for all tax consequences of the Settlement assessed against the City or as
determined by an appropriate government agency or authority. Under the agreement,
this responsibility will include providing each Union member who receives any
settlement distribution the appropriate tax documentation. The Union agrees that it will
indemnify the City for any taxes for which the City is liable as a result of the settlement
agreement.

You represent that the employees covered by the settlement are all members of the
Retirement Plan, and that the Retirement Plan has determined that the settlement
distributions are not subject to Retirement Plan contributions. You represent that the
employees covered by the settlement are not included within the State agreement under
section 218 of the Social Security Act (“section 218 agreement”), Retirement Plan
participants are members of a retirement system for social security tax purposes, and
neither the City nor the employees pay social security tax with respect to the
employees’ regular wages because of the employees’ participation in the Retirement
Plan.

Federal Income Tax Withholding

Section 3402(a) provides that, except as otherwise provided in this section, every
employer making payment of wages shall deduct and withhold upon such wages a tax
determined in accordance with tables or computational procedures prescribed by the
PLR-115737-16 3

Secretary. Section 3401(a) defines wages as all remuneration for services performed
by an employee for his or her employer, with certain specific exceptions.

Under section 3401(d), the term “employer” generally means the person for whom an
individual performs any service, of whatever nature, as the employer of such person.
However, under section 3401(d)(1), if the person for whom the individual performs the
services does not have control of the payment of the wages for such services, the term
“employer” (except for purposes of section 3401(a)) means the person having control of
the payment of such wages.

The employer under section 3401(d)(1) is responsible for income tax withholding
generally, but is not the employer for purposes of section 3401(a), which defines wages
for purposes of income tax withholding. As a result, the determination of whether
remuneration is wages under section 3401(a) is made on the basis of the common law
employer, even if another employer is the employer under section 3401(d)(1).

In Social Security Board v. Nierotko, 327 U.S. 358 (1946), the Supreme Court held that
back pay awarded to an employee constitutes wages for purposes of the Social Security
Act. Based on Nierotko, courts have held that awards that reflect compensation that
would have been paid to the employee, including back pay or future pay, constitute
wages subject to income tax withholding and Federal Insurance Contributions Act
(FICA) tax withholding. For example, Rivera v. Baker West, Inc., 430 F.3d 1253, 1258-
59 (9th Cir. 2005), held that awards for back pay and lost wages under Title VII of the
Civil Rights Act of 1964 constitute wages subject to income tax withholding. Blim v.
Western Elec. Co., 731 F.2d 1473, 1480 n. 2 (10th Cir. 1984), held that back pay is
taxable to the plaintiffs and subject to income tax and FICA tax withholding. Also, Rev.
Rul. 78-336, 1978-2 C.B. 255, holds that a court ordered back pay award paid to a
former employee is wages in the year paid rather than in the year earned and is subject
to income tax withholding at the rates in effect at the time the award is paid.

The settlement distributions here are in settlement of claims for unpaid wages and are
in effect back pay that has consistently been held to be wages under section 3401(a).
The payments represent remuneration for services performed by employees for the City
and are wages for federal income tax withholding purposes.

Social Security taxes

FICA taxes are imposed on wages as defined in section 3121(a) of the Code. The term
“wages” is defined in section 3121(a) as all remuneration for employment, unless
specifically excepted. “Employment” is defined in section 3121(b) as including any
service of whatever nature, performed by an employee for the person employing him or
her, with certain exceptions. FICA taxes include the Old-Age, Survivors, and Disability
Insurance Tax (social security taxes) and hospital insurance taxes (Medicare taxes).
Social security taxes are imposed by sections 3101(a) (employee’s portion) and 3111(a)
PLR-115737-16 4

(employer’s portion). Medicare taxes are imposed by sections 3101(b) (employee’s
portion) and 3111(b) (employer’s portion). The Additional Medicare Tax is imposed
under section 3101(b)(2) and consists of the employee’s portion only.
Neither the FICA nor the FUTA provisions contain a definition of employer similar to the
definition for income tax withholding purposes contained in section 3401(d)(1).
However, Otte v. United States, 419 U.S. 43 (1974), holds that a person who is an
employer under section 3401(d)(1) is also an employer for purposes of withholding of
the employee FICA tax imposed under section 3101. Circuit courts have applied the
Otte holding to conclude that the person having control of the payment of the wages
under section 3401(d)(1) is also the employer for purposes of section 3111, which
imposes the employer FICA tax, and for purposes of section 3301, which imposes the
FUTA tax on employers. See, for example, In re Armadillo Corp., 561 F.2d 1382 (10th
Cir. 1977).

Although the employer under section 3401(d)(1) is responsible for FICA tax withholding
generally, the employee’s common law employer is the employer for purposes of
determining whether the remuneration is subject to FICA and FUTA. The settlement
agreement relates to services performed in the employ of the City and therefore, the
issue of whether such services constitute “employment” for purposes of the social
security tax portion of the FICA is determined under section 3121(b)(7). Section
3121(b)(7) provides an exception from the definition of employment for service
performed in the employ of a State or any political subdivision thereof, or any
instrumentality of one or more of the foregoing which is wholly owned thereby, except
that the paragraph shall not apply in the case of certain services. Generally, the
exception provided by section 3121(b)(7) applies if the employee of the State, political
subdivision, or instrumentality is a member of a retirement system of such State,
political subdivision or instrumentality and if the employee is not covered under a
section 218 agreement.

If an employee of a state, political subdivision, or instrumentality thereof is covered
under an agreement under section 218 of the Social Security Act, the employee’s
remuneration is subject to social security taxes. See section 3121(b)(7)(E). When an
employee is not covered under a section 218 agreement, the employee’s remuneration
is generally subject to social security taxes unless the employee is a member of a
retirement system. Section 31.3121(b)(7)-2 of the regulations provides rules for
determining whether an employee is a “member of a retirement system.” These rules
generally treat an employee as a member of a retirement system if he or she
participates in a system that provides retirement benefits, and has an accrued benefit or
receives an allocation under the system that is comparable to the benefits he or she
would have received under Social Security. In the case of part-time, seasonal and
temporary employees, this minimum retirement benefit is required to be nonforfeitable.

Section 31.3121(b)(7)-2(e)(2) of the regulations provides that a plan must provide a
minimum level of benefits to an employee for the employee to qualify as a member of a
PLR-115737-16 5

retirement system. Under section 31.3121(b)(7)-2(e)(2)(ii), a defined benefit retirement
system maintained by a State, political subdivision or instrumentality thereof meets the
requirements of section 31.3121(b)(7)-2(e)(2) with respect to an employee on a given
day if and only if, on that day, the employee has an accrued benefit under the system
that entitles the employee to an annual benefit commencing on or before his or her
Social Security retirement age that is at least equal to the annual Primary Insurance
Amount the employee would have under Social Security. For this purpose, the Primary
Insurance Amount an individual would have under Social Security is determined as it
would be under the Social Security Act if the employee had been covered under Social
Security for all periods of service with the State, political subdivision or instrumentality,
had never performed service for any other employer, and had been fully insured within
the meaning of section 214(a) of the Social Security Act, except that all periods of
service with the State, political subdivision or instrumentality must be taken into account
(i.e., without reduction for low-earning years). Rev. Proc. 91-40, 1991-2 C.B. 694,
provides safe harbor formulas for defined benefit retirement systems for purposes of
meeting the minimum benefit requirement of the regulations.

You have represented that the Union’s member-employees receiving the payments are
members of the Retirement Plan, that the employees are not covered under the section
218 agreement between the State and the Social Security Administration, and that
participants in the Retirement Plan are members of a retirement system for purposes of
section 3121(b)(7)(F). If the employees receiving the settlement distributions qualify as
members of a retirement system with respect to year c, then the settlement distributions
made are not subject to social security taxes.

Medicare tax

Section 3121(u)(2) provides generally that remuneration for services paid to employees
of states, political subdivisions, or instrumentalities thereof is subject to Medicare tax
unless the continuing employment exception provided by section 3121(u)(2)(C) applies.
Section 3121(u)(2)(C) generally applies if the employee has been continuously
performing services for a state or local employer since March 31, 1986, if the service is
not covered under a section 218 agreement, and if the service meets other specific
rules set forth in section 3121(u)(2)(C).

Because the settlement distributions are remuneration for services performed in the
employ of the City, the settlement distributions made by the Union are wages subject to
Medicare tax unless the continuing employment exception applies. Thus, employee
Medicare tax is required to be withheld and paid from the distributions and the employer
Medicare tax applies to the distributions, unless the continuing employment exception
under section 3121(u)(2)(C) applies.

FUTA
PLR-115737-16 6

FUTA tax is imposed by section 3301 of the Internal Revenue Code on “wages,” as
defined in section 3306(b). Section 3306(b) defines wages as all remuneration for
employment, unless specifically excepted. Section 3306(c) defines “employment” as
including any service of whatever nature, performed by an employee for an employer,
with certain specific exceptions. Section 3306(c)(7) excludes from the definition of
“employment” service performed in the employ of a State, or any political subdivision
thereof, or in the employ of an Indian tribe or any instrumentality of any one or more of
the foregoing which is wholly owned by one or more States or political subdivisions or
Indian tribes.

The settlement is remuneration for services in the employ of the City, and thus the
exception from employment for FUTA purposes provided by section 3306(c)(7) applies.
Therefore, the settlement distributions made to member-employees are not subject to
FUTA taxes.

Reporting of Settlement Distributions

Section 6051(a) and the regulations thereunder provide that Form W-2, Wage and Tax
Statement, must be filed with respect to wages for services performed by an employee
for an employer from which income tax, social security tax, or Medicare tax was
withheld, or from which income tax would have been withheld if the employee had
claimed no more than one withholding allowance or had not claimed exemption from
withholding on Form W-4.

Because the settlement distributions are wages subject to income tax withholding and
Medicare taxes, Form W-2 should be used to report the payments.

Rulings

Accordingly, we conclude as follows with respect to the rulings requested:

(1) The settlement distributions are wages subject to federal income tax withholding.

(2) The settlement distributions are not subject to social security taxes provided the
recipient was a participant in the Retirement Plan and qualified as a member of a
retirement system under section 31.3121(b)(7)-2 with respect to services he or she
performed in year c.

(3) The settlement distributions are wages subject to Medicare tax unless the
employee’s services for year c were covered by the continuing employment exception
contained in section 3121(u)(2)(C).

(4) The settlement distributions are not subject to FUTA tax because services for the
City are excepted from employment for purposes of the FUTA.
PLR-115737-16 7

(5) The settlement distributions are reportable on Form W-2.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

                                   Sincerely,



                                   Lynne Camillo
                                   Branch Chief, Employment Tax Branch 2 (Exempt
                                   Organizations/Employment Tax/Government
                                   Entities)
                                   (Tax Exempt & Government entities)