Wages and the Employer-Employee Relationship

n 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). They were, however, income includible in the employees’ returns.

PREVIOUS GUIDANCE REVERSED
Revenue ruling 2004-110’s conclusion is contrary to previously published IRS guidance. The service had held in revenue rulings 55-520 and 58-301 that cancellation payments were (1) not wages subject to Social Security, Medicare or federal income tax withholding and (2) includible in the employee’s gross income in the year of receipt. Revenue ruling 58-301 modified revenue ruling 55-520 by classifying these payments, when made in a lump sum, as ordinary income, not capital gain. Revenue ruling 58-301 was subsequently distinguished by revenue ruling 74-252, which stated that the lump sum was primarily in consideration of the cancellation of the employee’s contract rights, rather than for the past performance of services through which the relinquished employment rights were acquired.

WHEN EFFECTIVE?
The IRS will not apply revenue ruling 2004-110 to employer payments to former employees made before Jan. 12, 2005, if made under facts and circumstances substantially the same as in revenue ruling 55-520 or 58-301.

For more information, see the Tax Clinic, edited by Mark Garay, in the March 2005 issue of The Tax Adviser.

—Lesli S. Laffie, editor
The Tax Adviser