Whether you win a lawsuit or settle out of court, the same tax rules apply. With that being said, typically, you will have a better chance of minimizing the tax bite if you are able to settle the case rather than receive a court judgment.

Although agreements between plaintiff and defendant that stipulate what is being paid and its tax treatment are not binding on the IRS (or the courts in later tax disputes), the IRS is more likely to accept its terms if there is a reasonable allocation of the damages to some of the categories discussed below.

For example, in a settlement of an employee termination suit, one would expect there to be some wages and related withholdings and payroll taxes (Form W-2), some nonwage emotional distress damages (Form 1099), possibly some personal physical injuries or physical sickness such as from a heart attack caused by work stress (nontaxable), some reimbursed business expenses (nontaxable, unless previously deducted) as well as some pension or fringe benefit payments (usually nontaxable).

Settlements and judgments are taxed according to the “origin of the claim,” which in layman’s terms refers to the item for which the plaintiff seeks recovery and that will usually fall into one or more of the following general categories:

Lost Wages or Profits

  • If you are an employee who sues for unlawful discrimination or termination, the bulk of your award will be taxed as wages and you will receive a W-2 from your former employer that includes the requisite withholding of income and employment taxes.
  • As a business, if you sue a competitor for lost profits, any recovery will be taxed as ordinary income and may also be subject to self-employment tax.

Loss in Value of Property

  • In lawsuits involving the loss in value of property caused by a negligent contractor, for example, your recovery of damages is not taxable, but instead reduces your property’s tax basis as long as it is less than your tax basis (generally, your original cost plus improvements).
  • On the other hand, if the property settlement exceeds your property’s tax basis, the excess is taxed as a capital gain (Schedule D).

Punitive Damages

  • These awards are always taxable as other income on line 21 of Form 1040, regardless of the underlying claim, even if all other components of the recovery are excluded from income.
  • As a practical matter, settlements (as opposed to judgments) will usually not involve punitive damages.

Interest

  • Many courts operate under the premise that a large portion of a claim will be based on the lost time value of money in the form of interest. Therefore, interest should always be included in any structured settlement in which payments are received in installments over time.
  • Interest income is always taxable (Schedule B), regardless of the underlying claim, even if all other components of the recovery are tax-free.

Personal Physical Injuries and Sickness Damages

  • Recoveries for personal physical injuries and sickness are not taxable unless you previously claimed a deduction for medical expenses related to the injury or sickness that provided you with a tax benefit in prior years.
  • You must include in income that portion of the settlement received that relates to any prior medical expenses deducted which resulted in a tax benefit.
  • The intent is to make a plaintiff whole for suffering the injury.
  • Types of injuries that are not considered physical injuries include –

o Emotional distress unless resulting from, or in connection with, a physical injury. Any damages received for medical care due to emotional stress are not included in your income unless previously deducted.
o Injury to one’s reputation
o Alienation of affections
o Discrimination and wrongful termination
o Violations of constitutional rights and right of privacy

Attorney Fees

Unless your damages are considered completely tax free, attorney fees can significantly impact how much you must pay Uncle Sam. Many lawyers handle such cases on a contingency fee basis, usually 30% to 40% of the damages. For tax purposes, you are treated as having received 100% of the settlement, even if your lawyer is paid directly by the defendant or his insurance company. In other words, you must include the attorney fee portion of a taxable recovery in your income (exceptions are discussed below).

This regulation has been further amplified by the IRS in recent audits of cases involving wage-based claims such as unlawful termination. The IRS requires that former employers, whether by settlement agreement or by judgment, specifically allocate attorney fees and issue the requisite Form 1099-MISC to both the former employee and the attorney. Failure to do so will result in the full amount of the award being classified as wage income to be reported on Form W-2 and subject to withholding and employment taxes.

A problem arises when you attempt to deduct the legal fees related to a dispute that does not involve a claim of unlawful discrimination or a properly structured class action (see below). Unless the suit is business-related, your only option is to claim attorney fees as a miscellaneous itemized deduction which is subject to the 2% of AGI limitation. Since the fees are also included in your income, they raise the 2% threshold (the nondeductible portion). To make matters worse, a taxable settlement would surely subject you to alternative minimum tax (AMT) meaning that you would completely lose any otherwise deductible legal fees as well as certain other tax benefits such as state taxes.

Suppose you file jointly and in 2015 receive a $150,000 settlement in connection with an emotional distress lawsuit that is not connected to a physical injury or sickness, whereby your lawyer is paid $50,000 directly by the defendant’s insurance company. Although you only received $100,000, the full $150,000 of the award would be included in your income, which would most likely thrust you into AMT. As a result, your miscellaneous deductions, including legal fees and certain other itemized deductions such as state taxes, would not be deductible. In effect, both you and your attorney pay taxes on his fee.

Some relief from this tax conundrum was granted by The American Jobs Creation Act of 2004 (AJCA 2004) which amended the Internal Revenue Code to allow a taxpayer to take an above-the-line deduction for attorney fees and court costs incurred in connection with cases involving unlawful discrimination, civil rights, employment-related claims, and certain claims against a government.  The deduction is limited to the taxable portion of the award and is available for fees and costs paid after October 22, 2004.

Therefore, using the previous example of a fully taxable employee discrimination award that includes emotional distress, regular wages and severance pay, your above-the-line deduction for legal fees would result in $100,000 of taxable income. Although this may still subject you to AMT, the effects would be minimized by the preservation of your legal fee deduction.

Another lawsuit category that allows favorable treatment of legal fees involves securities, non-personal-injury product liability and business practice class-action lawsuits whereby the court awards legal fees directly to counsel or establishes “qualified settlement funds” that are in accordance with Treasury regulations. For example, a utility company may systematically overcharge customers for certain fees, thus leading to a class action. The damages, in such cases, would be included in income as they would not be considered personal physical injury, nor would they be covered by AJCA 2004 as they are not discrimination or employment-related. Most class action cases, however, result in the establishment of a qualified settlement fund from which legal fees are paid directly. In accordance with Treasury regulations (section 1.468B-4), only the net amounts distributed to claimants are taxable. As a result, for such claims, the contingent legal fees are effectively deducted above the line.

Despite the effects of AJCA 2004 and Treasury regulations, significant incongruity remains with regard to the tax effects of various types of lawsuit awards. Until Congress acts to make all awards equitable in their tax treatment, this is likely to result in continued litigation between taxpayers and the IRS, not to mention that it is essential for taxpayers and their attorneys to be proactive in seeking tax advice during settlement negotiations.

If you have any further questions regarding taxation on awards and judgments, feel free to contact Bob Jahelka (BobJahelka@dsjcpa.com) or Victor  Belgiorno (VBelgiorno@dsjcpa.com).

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