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Settlements and Awards: What are the Tax Consequences for your Client?
By:
Kathleen Lach
Robert E. Mckenzie
You reached a settlement agreement for your client in a discrimination lawsuit against his former employer for $300,000. The Complaint alleged racial discrimination and harassment, assault, and intentional infliction of emotional distress. You sought damages for lost wages since your client was not promoted, medical bills for stress related ailments, and punitive damages.
You receive your 30% of the settlement, and you both are on your way.
A year and a half later, you receive a fax from this client with a Notice from the Department of the Treasury attached, demanding payment to the Treasury for back taxes owed in the amount of $100,000. Your former client's note reads: "What is this about? Please take care of it as soon as possible."
An important, but all too often forgotten, aspect of lawsuit
settlements and awards is the tax ramification. The taxation of
these payouts varies as much as the individual cases themselves.
Throughout each stage of negotiation, it is in the best interests
of all parties involved to keep tax considerations in mind.
"Includable" v. "Excludable"
All income, "from whatever source derived," is taxable, pursuant to Internal Revenue Code § 61, unless the Code specifically provides an exclusion. Prior to 1996, individuals interpreted the exclusions very broadly when classifying lawsuit awards.
In 1996, Congress amended IRC § 104(a)(2) which excludes certain settlements from taxation in an attempt to resolve the issues surrounding the exclusion of awards, particularly for damages related to "personal injury." The Code now explicitly states that punitive damages are not excludable from income. The amendment also limits damage exclusions to those awarded for "personal physical injury or physical sickness."
The Service published guidelines in November, 2000, for its Revenue Agents and Tax Auditors targeting awards and settlements. The guidelines focus on the government's position in auditing returns and classification of this category of income ( awards in various types of cases, i.e., personal injury, employment discrimination, etc.).
Throughout your negotiations, keep the following points in mind:
1. What was the underlying injury?
Excludable deductions are limited to those awarded for loss due to actual physical injury, and expenses incurred as a result of the actual physical injury. Awards for emotional distress are not excludable, unless the emotional distress is a result of the physical injury. However, reimbursement for medical expenses, even those related to emotional distress, may be excludable.
Distinguishing between physical and non-physical injury has become an area of great controversy. In the seminal case involving tax implications of awards and settlements, Commissioner v. Schleier,(1) the Supreme Court emphasized two parameters as guidelines for exclusion.(2) The Court held that in order for an award or settlement to be excluded under Code §104(a)(2), (1) the claim must be "based on tort or tort type rights;" and (2) the damages must be received "on account of personal injuries or sickness."
The meaning of "personal injury" had divided the circuits, and Congress intervened by enacting the 1996 amendment to §104, which now reads "personal physical injuries or physical sickness." The legislative history made it clear that it was Congress' intent to tax awards resulting from claims where there was no actual physical injury.(3)
Unfortunately, straightforward application of the amendment is not a simple task. For example, the issue was addressed in a letter ruling by the Service in October, 2000,(4) which established artificial time frames to distinguish between actual physical injury and emotional distress (using contrived timing distinctions such as "First Pain Incident" and "First Physical Injury", and insinuating that physical contact which did not produce "cuts, bruises, etc.," or that did not cause extreme pain, were not physical injuries). (6)
2. Allocation of the Payout
If your case proceeds to trial, and you prevail, a jury will most likely award your client a certain amount for lost wages, a certain amount for punitive damages, etc. Since the nature of the award is specified, the tax implications are usually clear under these circumstances.
However, when a case is settled for a lump sum, the tax implications may not be as clear. If you do not attribute each portion of the payment to a theory of recovery (back wages, punitive damages, etc.), you leave your client open to the allocation of the IRS. Your client must then either accept additional taxes, or incur additional costs to challenge the IRS' allocation.(7)
Other Factors to Consider
Punitive damages are taxable income.
Damages for emotional distress are includable as income, unless the emotional distress was the result of physical injury.
Does your client in the example above owe tax on your portion of the settlement proceeds, or $100,000 which he never saw? The IRS says "Yes." However, courts are split on this issue.(8)
Your fee may be deductible if the full award is taxable to the
client.
If you represent the defendant in the case, it must report payouts for lost wages. Your client may owe taxes on those "wages."
If the IRS finds that your client failed to report a taxable settlement, he will face penalties in addition to taxes and interest. An employer which fails to report taxable wage settlements also will face additional taxes, penalties and interest.
How do they find you?
The new IRS guidelines provide investigators with the following tips about where to look for potential audit "targets."
In Summary
When planning your legal strategies and theories in any case,
keep tax implications in mind. Prior to final resolution of the
matter, you may want to consult a tax advisor to discuss remedies
and allocation issues under the facts of the case.
1. 115 S. Ct. 2159, 515 U.S. 323 (1995).
2. The Court in Schleier considered the nature of settlement proceeds from an ADEA claim.
3. H.R Conf. Rep. No. 737, 194 superth Cong., 2d Sess. 301 (1996).
6. For further discussion of the Section 104 amendment, see Rev. Rul. 96-65.
7. For allocation battles, see Greer v. U.S., 207 F.3d 322 (6th Cir., 2000); Reisman v. Commissioner, 87 AFTR2d 2001-783 (6th Cir., 2001).
8. Srivastava v. Commissioner, 220 F.3d 353 (5th Cir., 2000).
