The answer to this question is simple: because otherwise you may be unhappy with the results. The crafting of precise and detailed language addressing the nature and release of specific claims is vital to ensuring that a settlement agreement is respected.
Consider, for example Durret v. Commissioner, T.C. Memo 1992-682, where the court held that a taxpayer’s belief that he was settling a claim which was not set forth in the settlement agreement was insufficient to support his claim that the recovery was excludable from gross income. In other words, the court said the taxpayer’s intent was not enough—it must be in writing. Consider too Foster v. Commissioner, T.C. Memo 1996-26, where the court held that correspondence between litigants that contemplated favorable tax treatment (i.e. to cover potentially excludable claims) was insufficient to support the taxpayer’s argument that the proceeds were not taxable; the court required it to be in the language of the settlement agreement itself.
Careful drafting is important and it increases one’s chances that the settlement agreement (and the tax allocations) will be respected by the courts and the IRS; but it is not always enough. That is, the express language of the settlement agreement is not necessarily controlling. For example, in Peaco v. Commissioner, T.C. Memo 2006-48, the taxpayer settled a claim with his insurance company that included compensation for back and front pay, and for pain and suffering. The settlement agreement contained language that specifically stated that all payments made were for pain and suffering as a result of a personal physical injury—and not for front or back pay. However, the court held that the entire recovery was taxable because the settlement agreement did not reflect the true intentions of the parties, and that the taxpayer failed to establish that any amount of the recovery was due to personal physical injury.
To better increase one’s chances that the settlement agreement’s express allocations will be respected for tax purposes, it should be entered into by the parties in an adversarial context, in good faith, and conducted at arm’s length. McKay v. Commissioner, 102 T.C. 465 (1994). In addition, the IRS has stated that allocations which bear a “reasonable relationship” to what a jury might have been expected to award will be respected. Rev. Rul. 85-98.