Not All Back Pay is Created Equal The Arkansas Supreme Court Holds Employers Cannot Withhold Taxes on Back Pay Awards by Allen C. Dobson and Travis Bo Loftis, Sr.
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n late 2007, the Arkansas Supreme Court created a complex challenge for employers subject to a judgment or settlement for wrongful termination when it decided Arkansas Department of Health and Human Services v.
Storey.1 The issue before the court was whether the Arkansas Department of Health and Human Services (“DHHS”) should have withheld taxes from the amount it paid as a judgment to the plaintiff, Betty Storey, for “lost wages, benefits, and other remuneration” recovered under the Arkansas Whistleblower Act.2 The court answered this question in the negative, arguably rejecting both federal statutory and common law in the process. The immediate impact of Storey is that DHHS was not released from the judgment even though it paid the entire award to the plaintiff, minus the withholdings. This article examines the rationale behind the Storey decision and analyzes the problem it poses for employers who are faced with the difficult task of deciding if they should deduct federal income taxes from a back pay amount awarded to a former employee. I. To Withhold or Not to Withhold: That is the Question. Since 1943, the Internal Revenue Service (“the IRS”) has required employers to deduct from their employees’ paychecks a statutory defined percentage of their employees’ pay and remit this amount to the federal government.3 Employers are well aware of the steep penalty that will result if they fail to withhold the required amounts from an employee’s check.4 This penalty can even be personally assessed against the person responsible for withholding and paying the tax.5 Therefore, wise employers automatically deduct federal income taxes from any compensation paid to an employee, including amounts paid as a result of an employee’s lawsuit for wrongful termination. With the Arkansas Supreme Court’s ruling in Storey, this default practice of automatically deducting federal income tax becomes a dangerous one. No longer can an employer assume an award is subject to federal withholding. If it does, it might find itself subject to an unsatisfied judgment claim by the plaintiff. This will result in the employer having to pay the employee the additional amounts that it withheld as taxes and then having to try to recoup this sum from the IRS. Meanwhile, the employer will be subject to additional costly litigation against both the employee and the IRS — this after the employer has paid to defend the original suit. This places the employer in an impossible Morton’s Fork6 situation. The employer can choose not to withhold taxes on a back pay award and risk having one of its management representatives be held personally liable by the IRS for the amount of the tax it failed to withhold, or it can choose to withhold taxes and have the trial court declare that the judgment has not been satisfied, leaving the employer vulnerable to execution on the unpaid judgment. 16
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A. Prevailing Federal Case Law The Internal Revenue Code (“the IRC”) and federal case law lead to a relatively simple resolution to this issue. Under the IRC, an employer must deduct the required withholding amounts from “wages” paid to an employee.7 The IRS defines wages as “all remuneration… for services performed by an employee for his employer.”8 In addition, the IRS does not limit what must be considered wages to the traditional weekly paycheck; it includes payments to employees as wages, even when they are no longer employed. The governing treasury regulations provide that “[r]emuneration for employment … constitutes wages even though at the time paid the relationship of the employer and employee no longer exists between the person in whose employ the services were performed and the individual who performed them.”9 Further, with regard to employment taxes and the collection of income tax at the source, the IRC expressly states that “[a]ny payments made by an employer to an employee on account of dismissal, that is, involuntary separation from the service of the employer, constitute wages regardless of whether the employer is legally bound by contract, statute, or otherwise to make such payments.”10 This broad view of wages and the employment relationship in general was first articulated by the United States Supreme Court in Nierotko v. Social Security Board.11 (Nierotko was the primary case relied on by DHHS in Storey). In Nierotko, an employee was reinstated with back pay by the National Labor Relations Board after the Ford Motor Company wrongfully discharged him for participating in union activity.12 The Social Security Board refused to credit his old age and survivors’ insurance account with the amount of the award, claiming the payment did not constitute “wages.”13 Ni-