Penalty wages are taxable but not subject to withholding
Upshot: California penalty wages are taxable to employees, but not subject to withholding.
Note: Legal memoranda are intended as private advice from the IRS to the requesting party. They may be used for informational purposes only; they may not be used or cited as precedent. (ILM 201522004, INFO 2016-0026)
So long, it’s been good to know ya. Under Section 203 of the California Labor Code, in addition to a terminating employee’s final pay, you’re liable for up to 30 calendar days of penalty wages if you willfully fail to pay the final wages on time. According to the state labor department, willfulness is a low barrier; you act willfully if you know final wages are due, but fail to pay them.
The IRS interpreted the penalty wages payable under this statute as similar to liquidated damages that are payable under the Fair Labor Standards Act. Those payments are taxable to employees, but aren’t wages subject to withholding.
IRS: Penalty wages imposed under this state law are due to the employer’s actions (or inactions) with respect to a final paycheck; they are not remuneration for services because employees have no vested interest in them.
The IRS further concluded that since penalty wages are similar to liquidated damages, they should be reported in Box 3 of Form 1099-MISC, not in Box 1 of Form W-2, as other compensation.
STATE LAW CHECKUP: California isn’t the only state that requires you to pay penalty wages, in addition to regular wages, to employees. Some states require you to pay penalty wages to current and terminating employees; others limit them to terminating employees. To help you get a handle on this area of state wage payment laws, this month’s Page 8 chart summarizes states’ penalty wage provisions. To get the full story on your state’s wage payment laws, surf to your state labor department’s website.
