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In a recent information letter (No. 2016-0026), the Internal Revenue Service (IRS), Office of Chief Counsel concluded that "waiting time penalties" paid by employers to their employees under California law are not wages and should be reported as other compensation on Form 1099-MISC and not Form W-2. This ruling is consistent with a Technical Advice Memorandum (TAM) issued last year. (TAM No. 201522004, 5-29-2015.)

While a TAM or information letter may not be cited as precedent, these rulings do provide important insight into how the IRS may rule under a similar set of facts and circumstances.

California's waiting time penalty

Under California Labor Code Section 203, a waiting time penalty applies when an employer fails to timely pay wages to employees who are discharged or quit. If the late payment penalty applies, the employer must continue to pay for up to 30 days the employee's average weekly wage from the due date of the final wage payment and until those final wages are paid. (California Department of Industrial Relations website.)

Why the IRS rules the waiting time penalty is not wages

In arriving at its conclusion that the California waiting time penalty is not wages, the IRS points to a case decided by the Supreme Court of California wherein it held that "California Labor Code Section 203 is not designed to compensate employees for work performed. Instead, it is intended to encourage employers to pay final wages on time, and to punish employers [that] fail to do so." (Pineda v. Bank of America, 241 P.3d 870 (2010).)

Accordingly, the IRS ruled that California's waiting time penalty is similar to the liquidated damages in Revenue Ruling 72-268 that were held not to be wages for employment tax purposes because the penalty is statutorily imposed for employer misconduct that is additional to the employee's wages. Furthermore, 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.

Reporting payments of the waiting time penalty

In its information letter, the IRS explained that payments to employees that constitute fixed or determinable income, but do not compensate them for services, are reported on Form 1099-MISC. For example, liquidated damages, judgments, and settlements that are income, but do not constitute compensation, are reported as "Other Income" in box 3 of Form 1099-MISC. The Instructions for Form 1099-MISC similarly state that punitive damages are reportable in box 3. Therefore, the IRS concluded that waiting time penalty payments are subject to reporting in box 3 of Form 1099-MISC, in the same manner as other non-compensatory liquidated damages, rather than on Form W-2.

Ernst & Young LLP insights

This IRS conclusion is favorable to employers because when reported on Form 1099-MISC, payments of the waiting time penalty are exempt from Social Security/Medicare (FICA) and unemployment insurance taxes.

Employers that have reported California waiting time penalty payments on Form W-2 should consider the benefits of filing Forms W-2c and Forms 1099-MISC, not only for the benefit of obtaining FICA refunds, but to avoid potential reporting penalties. In its information letter, the IRS indicated that penalties under IRC Sections 6721 and 6722 may be imposed for using Form W-2 rather than Form 1099-MISC.

Finally, it is important to note the California authorities have also ruled that waiting time penalty payments are not wages subject to the withholding of California payroll taxes. (California Department of Industrial Relations website.)

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