Termination compensation

[Onefish]

Since she retired,  and pursuant to a plan the firm labels "termination compensation," my wife has been receiving payments from the partnership she worked for.  The plan calls for payments based on one year's salary payable over a ten-year period. The payments also include interest tied to the balance of the payments made each month. The interest is described as such in the written plan.

The firm reports the principal as wages on a W-2, and the interest is reported in Box 7 of a 1099-MISC, "Nonemployee Compensation." Withholding and FICA taxes are all applied as if the payments were for salaries and wages.

One effect of the way this California firm chooses to treat the payments, i.e., as salary and wages, is that the firm pays CASDI-E taxes even though we now live in another state and there's no chance she will be injured on the job.

The firm refuses to characterize the payments to match their written description of the plan.  So my question--how should I report this income?  The agreement runs for 10 years and causes problems on the return for our new state--New Mexico.

[Opus 17 · Accepted solution]

The termination wages are properly reported on a W-2 per IRS rules and a recent court case.  

The interest is more complicated.  A 1099-MISC box 7 is probably wrong; I would be more inclined to report it either on a 1099-INT or as part of the W-2 wages.  If you report it as any other than self employment income, the IRS will probably send you a letter asking for an explanation or payment of the tax.  You may want to pay for professional advice.  

if you want to treat the money as W-2 wages, I believe that after you enter the 1099 there is a listing of special circumstances and a box you can check that says something like “this money should have been on my W-2“.  That will cause TurboTax to add it to the W-2 and prepare a special form, you would not need a schedule C and you would pay the employee half of Social Security and Medicare tax but not the employer half.

to treat it as interest, I would leave the 1099 off your tax return entirely. Add the amount of interest in the interest portion of the interview.  Don’t e-file; print your return and file by mail. Attach a copy of the 1099 and a written explanation as to why you are treating it as interest instead of self-employment income.

[Onefish]

Thanks; that's very helpful.  Do you have a reference for the court case?

The W-2 wages at least turned out not to be a problem. New Mexico claims all of the wages as NM income because we were domiciled here for the entire year. But CA allowed us to deduct the "wages" from CA income and will refund all of the withheld taxes. The CA SDI deduction is still absurd but immaterial. We will see if we can at least get the firm to treat the payments as NM income and withhold taxes accordingly.

Again, thank you.

[Opus 17]

https://www.supremecourt.gov/opinions/13pdf/12-1408_6468.pdf

FICA defines “wages” broadly as “all remuneration for employment.” §3121(a). As a matter of plain meaning, severance payments fit this definition: They are a form of remuneration made only to employees in consideration for employment. “Employment” is “any service . . . performed . . . by an employee” for an employer. §3121(b). By varying according to a terminated employee’s function and seniority, the severance payments at issue confirm the principle that “service” “mea[ns] not only work actually done but the entire employer-employee relationship for which compensation is paid.”