United States: Wait's Over: IRS Says Waiting Time Penalties Aren't Wages

We've long known that California law does not treat Labor Code Section 203 penalties as "wages." Earlier this year, the IRS published its view on how to treat those penalties (often referred to as "waiting time penalties" or WTPs) for purposes of federal income and employment taxes. A Chief Counsel Advice ("CCA") memo concludes that WTPs are not wages for purposes of federal income or employment tax.

Labor Code Section 203 makes a California employer liable if it has willfully failed to timely pay final earned wages to an employee whose employment has terminated. The offending employer must pay an amount equal to the employee's daily wages from the due date until the date of payment, up to a maximum of 30 days. WTPs can result so long as the employer knew what it was doing, the late payment occurred, and the timing of the payment was within the employer's control. The employer's intent to pay the wages on time would not be a defense. The only viable defense would be a showing that the employer, in good faith, disputed that any further final wages were owed on the due date.

When WTPs are paid, are they treated as wages? The California Department of Industrial Relations (DIR) website reports that WTPs are not wages, and thus an employer need not take deductions from a penalty payment.

But what is the view of the federal taxing authority—the IRS? The characterization of WTPs implicates several sections of the Internal Revenue Code. As to any payment of "wages," Sections 3101 and 3111 impose social security tax and Medicare tax (aka FICA tax), Section 3301 imposes federal unemployment tax, and Section 3402(a) requires income tax withholding. All these IRC sections define "wages" as remuneration paid for employment or services performed by an employee for his employer, with certain exceptions.

The General Counsel's CCA begins by recognizing that "wages" is applied broadly for income and employment tax purposes. In United States v. Quality Stores, Inc., 134 S. Ct. 1395 (2014), the Court held that severance payments made to involuntarily terminated employees are wages for FICA tax purposes, and in Social Security Board v. Nierotko, 327 U.S. 358 (1946), the Court defined "employment" to mean not only the work an employee performs, but the entire employer-employee relationship in which the employer pays compensation to the employee.

The CCA also considers contrasting California authority: the California Supreme Court, in Pineda v. Bank of America, rejected the notion that WTPs are "wages" recoverable as restitution under California's unfair competition law. The CCA also cites Revenue Ruling 72-268, which addressed the income and employment tax status of payments made under the FLSA for liquidated damages and for previously unpaid minimum and overtime wages. The FLSA makes employers liable for liquidated damages equal to the amount of unpaid minimum and overtime wages, unless the employer can show that the non-payment was based on reasonable grounds to believe that the failure to pay those wages was not in violation of the FLSA. The Revenue Ruling held that payments of unpaid minimum and overtime wages were wages for federal income and employment tax purposes, but that the liquidated damages were not.

The CCA concludes that WTPs differ from severance pay (as considered in Quality Stores) because WTPs, unlike severance pay, do not result from the employee's service but rather result from the employer's failure to timely pay final wages. WTPs thus resemble liquidated damages owed under the FLSA: WTPs are statutorily imposed penalties owed for employer misconduct—penalties that are in addition to wages and that reflect the extent of the employer's misconduct rather than the level of the employee's services. The IRS thus concluded that, notwithstanding the traditionally broad application of the term "wages," WTPs are not wages for purposes of federal income and employment tax.

The CCA applies only to WTPs and does not apply to meal and rest payments made under California Labor Code Section 226.7. Under California law, these payments are sometimes called penalties and sometimes called wages. The CCA volunteers the IRS's own, tentative view: "Because the meal and rest period payments are essentially additional compensation for the employee performing additional service during the period when the meal and rest periods should have been provided, it appears those payments would be wages for federal employment tax purposes."

A CCA is prepared by the IRS Office of Chief Counsel for field or service center employees and may not be cited as precedent by any taxpayer. Nevertheless, CCA 201522004 is helpful because it sets forth current IRS thinking on the federal income and employment tax treatment of WTPs and, perhaps to a lesser degree, the tax treatment of meal and rest payments. Although not citable precedent, the CCA provides welcome guidance after years of uncertainty concerning the federal income and employment tax treatment of WTPs.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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