If an employer is required by state law to made additional payments to an employee when their final wages are not paid within a specified time period is that payment subject to federal payroll taxes and/or federal withholding? This is the issue addressed in Chief Counsel Advice 201522004.
The state of California requires employers to pay final wages to an employer by due dates imposed by the State Labor Code for any employee who is discharged or quits. If the employer fails to make the payment by that date, the wages of the employee continues from the due date until the amount is paid, but for no more than 30 days. While the rule applies regardless of whether the employer intentionally violated the rule or otherwise acted with malice, the penalty does not apply if the employee actively avoids the payment by “hiding” from the employer.
The memorandum describes some of the authorities with regard to whether certain payments are wages. The 2014 Supreme Court case of United States v. Quality Stores, Inc. found that severance payments to an employee are wages for payroll tax purposes. As well, the IRS has ruled in Rev. Rul. 2004-110 that payments made to an employee as consideration for cancellation of an employment contract and relinquishment of contract rights is also subject to all such taxes. In both cases it was concluded the payment related to the employment of the employee and services the employee had provided (even when the relationship had been terminated).
However the memorandum notes that Rev. Rul. 72-268 considered the case where an employee is paid unpaid minimum wages, unpaid overtime compensation and liquidated damages for damages under the Fair Labor Standards Act of 1938 (FLSA). While the unpaid minimum wages and unpaid overtime compensation are considered taxable for payroll tax purposes, the ruling concluded that the payment of liquidated damages per the FLSA are not wages for payroll tax purposes, even though they are includable in the income of the employee.
So now the memorandum turns to the payment of the late payment penalty to the former employee. The IRS concludes the answer is that, no, the late payment penalty is not subject to payroll taxes or withholding in this case.
The ruling holds:
The late payment penalty in this case is different from severance pay because it is based on the employer’s failure to pay final wages on a timely basis. It is imposed by state law because of the employer’s action or inaction with respect to the final paycheck. The employee has no right to payment of the late payment penalty based on the service of the employee; it only applies if the employer fails to pay wages on a timely basis. The payment of the late payment penalty also does not satisfy the definition of wages in Rev. Rul. 2004-110 because the penalty is not part of the terms and conditions of employment, but a separate statutorily imposed penalty.
The late payment penalty is similar to the liquidated damages in Rev. Rul. 72-268 that were held not to be wages for employment tax purposes. The late payment penalty is a statutorily-imposed penalty for employer misconduct that is additional to the employee’s wages. The penalty varies in amount based on the extent of the employer’s misconduct (i.e., the number of days that the employer fails to pay the wages after the due date) rather than the level of services performed by the employee, and is not a substitute for the employer’s liability for the payment of wages. Based on Rev. Rul. 72- 268, we conclude that the payment of the late payment penalty is not wages for federal employment tax purposes.