The Taxability of Back Pay Awards

Components of damage awards in employment cases that relate to physical injuries are generally not found to be taxable, while components relating to back wages are. A variation on this theme was recently explored in a New Jersey Law Division case that examined whether taxes should be deducted from a back pay award emanating from a labor arbitration decision, as opposed to a scenario in which the jury award of damages (or settlement) is rendered pursuant to a statutory framework. In ATU, Local 1317 v. DeCamp Bus Lines, 382 N.J. Super. 418 (L. Div. 2005), the result turned in large part on the court’s analysis of whether the individual remained an employee, and in ruling that he did, the court distinguished a contrary Law Division case, setting the stage for an ultimate resolution by the appellate courts.

The IRS takes the position that back pay paid to an employee or former employee is wages, from which taxes should be deducted, even if the period of time covered by the award is one in which no employment services were provided by the employee. That position rests on the United States Supreme Court holding in Social Sec. Bd. v. Nierotko, 327 U.S. 358 (1946). In Nierotko, the National Labor Relations Board found that Ford Motor Company wrongfully discharged an employee, Joseph Nierotko, for union activity. The Board reinstated Nierotko and awarded him “back pay.” Thereafter, Nierotko sought Social Security credit toward his benefits. However, the Supreme Court held that an employee’s award of “back pay” received during a period of time that he was wrongfully separated from his job should be treated as wages under the Social Security Act. The Nierotko court further explained that “back pay” is clearly “remuneration” and is not a fine or penalty for an employer’s wrongdoing. Despite the fact that Nierotko did not perform services for his employer during the period for which he was awarded back pay, the Supreme Court held that “service” should not be limited to “productive activity.” Instead, the Nierotko court determined that “service” encompasses not only work actually performed but also the entire employer-employee relationship for which the employer pays compensation to the employee.