Bonuses for signing or ratifying a contract
A detailed Revenue Ruling considers whether amounts an employer pays as bonuses for signing or ratifying a contract are wages for purposes of the FICA, FUTA and Federal income tax withholding.

Two example situations are provided:

• Baseball Club negotiates an employment contract with an individual player. It is the first contract between the Club and the player. The contract provides that the player receives a signing bonus if he reports for spring training at the time and place directed by the Club. The contract provides that the signing bonus is not contingent on the player's future performance of services.
  
  
• An employer negotiates a collective bargaining agreement (CBA) with a union representing a group of its employees. The CBA will take effect on the "ratification date," which is the date it is ratified by a majority of the union members covered by the agreement. The CBA provides that each employee covered by the terms of the agreement who is employed by the employer as of the ratification date receives a bonus. Each such employee is paid the same amount regardless of compensation, seniority, position and whether or not the employee voted for ratification. In addition, each eligible employee receives the payment even if the employee had not performed services for the employer before the ratification date. Finally, the CBA provides that the payment is not contingent on the employee's future performance of services.

Revenue Rulings dating back to between 1958 and 1974 stated that, in these situations, the bonuses would not be treated as wages. The reasoning now is that a payment is not wages if the employee provides clear, separate, and adequate consideration for the employer's payment that is not dependent upon the employer-employee relationship and its component terms and conditions. The fact that the contract provides that the bonus is not contingent on the performance of future services is not relevant.

Therefore, amounts an employer pays as bonuses for signing or ratifying a contract in connection with the establishment of the employer-employee relationship, as in the two example situations, are wages for purposes of FICA, FUTA, and Federal income tax withholding. The earlier Revenue Rulings are revoked.

This Ruling is not backdated and will not be applied to any signing bonus, sign-on fee, or similar amount paid to an employee in connection with the employee's initial employment with the employer pursuant to a sign-on agreement or other contract entered into before January 12, 2005, provided the amount was paid under facts and circumstances that are substantially the same as in the 1958 and 1974 Rulings.

Further information:
www.ustreas.gov/press/releases/js2114.htm
www.irs.gov/pub/irs-drop/rr-04-109.pdf



Consideration for cancellation of an employment contract and relinquishment of contract rights
Another related Revenue Ruling considers whether an amount paid to an employee as consideration for the cancellation of an employment contract and relinquishment of contract rights is ordinary income, and wages for purposes of FICA, FUTA and Federal income tax withholding.

The following example situation is provided:

• An employee performs services under a written employment contract providing for a specified number of years of employment. The contract does not provide for any payments to be made by either party in the event the contract is cancelled by mutual agreement. Before the end of the contract period, the employee and the employer agree to cancel the contract and negotiate a payment from the employer to the employee in consideration for the employee's relinquishment of his contract rights to the remaining period of employment.

Earlier Revenue Rulings dating back to between 1955 and 1975 concluded that

• a compromise settlement for the cancellation of a two-year employment contract prior to its normal cancellation date is not wages for FICA and tax withholding purposes.
  
  
• a lump sum payment received by an employee as consideration for his agreement to cancel the remaining period of a five-year employment contract during the second year of the term and to relinquish his contract rights is ordinary income, not capital gain, and is not subject to FICA and Federal income tax withholding.

However, other Rulings have taken a different view where

• the payments are in the nature of dismissal payments provided for under the terms of the contract, rather than as consideration for the relinquishment of interests the employee had in the employment contract, or
  
  
• the payment was primarily in consideration of the cancellation of the employee's original contract rights rather than primarily in consideration of the past performance of services through which the relinquished employment rights were acquired.

The reasoning now is that a payment is not wages if the employee provides clear, separate, and adequate consideration for the employer's payment that is not dependent upon the employer-employee relationship and its component terms and conditions.

Therefore, a payment as consideration for canceling the remaining period of an employment contract and relinquishing contract rights is part of the compensation the employer pays as remuneration for employment, as in the example situation, is wages for purposes of FICA, FUTA, and Federal income tax withholding. This conclusion applies regardless of the name by which the remuneration is designated or whether the employment relationship still exists at the time the payment is made. The earlier Revenue Rulings are modified or superseded, as appropriate, in line with the new Ruling.

This Ruling is not backdated and will not be applied to any payment that an employer made to an employee or former employee before January 12, 2005, provided the amount was paid under facts and circumstances that are substantially the same as in the 1955 and 1958 Rulings.

Discuss this news item in the PayPerShop Forum

...back to 25 November 2004


Further information:
www.ustreas.gov/press/releases/js2114.htm
www.irs.gov/pub/irs-drop/rr-04-110.pdf