Yes. Practically all settlement proceeds for back wages are taxable. Report all forms of W-2 and 1099-MISC. The 1099-MISC
probably contains taxable income from proceeds that were punitive in some form.
A W-2 would represent payment for actual back wages.
When entering the 1099-MISC, indicate that the form
was received from a lawsuit and the amount (if any) that represent back wages on the 1099-MISC.
(See attached screenshot.)
Here's some background that may be helpful:
Any portion of the
settlement proceeds paid to compensate for wages must be reported through Form
W-2, and will essentially be treated by the employer as a payroll
check. See I.R.C. §
6051.
The employer will
deduct applicable taxes and withholdings for Social Security and Medicare, and
will remit the matching taxes to the IRS. See I.R.C. § 3402(a).
Any portion of the
settlement proceeds paid for non-wages are typically reported through Form
1099-MISC as “other income.” See I.R.C.
§ 6041. The employer will not deduct any taxes or withholding and will
not remit any matching taxes on these non-wage payments.
Plaintiffs often
request that employers treat the entire settlement payment as “other income”
under Form 1099-MISC, to avoid the deduction of taxes and withholdings.
While this practice may temporarily result in a larger settlement check for the
plaintiff, it subjects both the employer and the employee to substantial
potential tax liability.
If portions of the
settlement proceeds are misclassified as “other income” when, in fact, they are
wages, the plaintiff will be responsible for all taxes, including the
employer’s portion. If the employee is unable to satisfy the tax burden
of settlement proceeds, the IRS will likely turn to the employer for
payment.
In addition, if an
employer fails to deduct and withhold income tax amounts by treating the
employee or former employee as a nonemployee, the employer may be subject to
additional liability, penalties, and interest. See I.R.C. § 3509.
