There is an active discussion going on in my company between HR & Payroll. Hopefully someone else can provide insight. There is a California ee who is basically going to be paid a settlement to avoid any litigation. Is the settlement considered taxable wages or could they be paid through AP. Would the settlement wages need to be reported on W-2, 1099, etc?

They should be reported as wages and put on the w-2. This also means that the employer is on the hook for their share of employement taxes on those wages.

Depends on what the settlement is for.

Agreed, but most of the time we have fully taxable wages. IRS really tighted those rules up a while back and there is not much left in the way way of exceptions.

Depends on the terms of settlement if its back wages,front wages yes that would be taxable. If it is for pain,and suffering no. Without knowing the wording in the settlement agreement it is difficult to say.

In 1996 Congress amended IRC 104(a) so that damages are excludable from income under section 104(a)(2) only if they are compensation for "personal physical injuries or physical sickness." Non-physical injuries such as emotional distress are now clearly taxable.

The only types of non-taxable payments are narrowly defined physical damages and certain expense reimbursement. Even attorney portions of the settlements have gotten complicated.

IRS rules on settlements (http://www.irs.gov/businesses/page/0,,id=7053,00.html)

In 1996 Congress amended IRC 104(a) so that damages are excludable from income under section 104(a)(2) only if they are compensation for "personal physical injuries or physical sickness." Non-physical injuries such as emotional distress are now clearly taxable.

The only types of non-taxable payments are narrowly defined physical damages and certain expense reimbursement. Even attorney portions of the settlements have gotten complicated.

IRS rules on settlements (http://www.irs.gov/businesses/page/0,,id=7053,00.html)
Really OK I will rescind that post good catch DAW. Hey I just found out you can delete a whole post. When was that feature added?
JoeC

It's always been there.

Well thats handy never noticed until now. It's so rare that I am wrong could be the reason. :D

Really OK I will rescind that post good catch DAW. Hey I just found out you can delete a whole post. When was that feature added?
JoeC

Don't feel bad. I have worked for some fairly large employers with in house legal departments that seem to keep missing that one for some reason. It always surprised me that lawyers who could charge serious money to negotiate settlement agreements could include provisions regarding the taxability of payments that were not legal on their face. Prior to 1996 the laws in fact were very different and apparently there are a lot of lawyers who learned under the old rules. I have had to refuse to make settlement payments because the instructions were not legal on their face. Good way to not get a X-mas card from Legal that year. Fortunately while that IRS page is dense and hard to read, but also has everything pretty well spelled out. And even lawyers have trouble arguing with IRS.

Don't feel bad. I have worked for some fairly large employers with in house legal departments that seem to keep missing that one for some reason. It always surprised me that lawyers who could charge serious money to negotiate settlement agreements could include provisions regarding the taxability of payments that were not legal on their face. Prior to 1996 the laws in fact were very different and apparently there are a lot of lawyers who learned under the old rules. I have had to refuse to make settlement payments because the instructions were not legal on their face. Good way to not get a X-mas card from Legal that year. Fortunately while that IRS page is dense and hard to read, but also has everything pretty well spelled out. And even lawyers have trouble arguing with IRS.
Another thing about settlement agreements that some lawyers miss on back pay front pay is Social security tax. If the agreement does not specify how the tax is dealt with the employer can take the amount he would have to pay,and deduct it from the employees award. That is the employers contribution to S.S is deducted from the settlement,unless stipulated otherwise in the settlement.
JoeC