Awards and Settlements Tax Representation

Commonly, the tax ramifications of litigating or settling a case are not considered until after the fact. If approached in this manner, litigants and attorneys are missing a valuable opportunity to improve their position. With the changes to tax law put in place with the 2017 tax act, many litigants are in for a shock when they learn they will no longer be able to deduct attorney’s fees in many scenarios. The taxpayer will still be taxed on 100% of the settlement including the amount paid as the attorney’s contingent fee however.

awards and settlements tax issuesIn many instances, tax treatment will have a significant and direct impact on the finances of a client. Therefore, it is preferable to undertake a tax analysis from the outset of a case. In this regard, tax awards and settlements typically are much more attractive if taxed at capital gains rates rather than ordinary income, or better yet, if they are completely tax-free. Where neither of these results are possible, a structured settlement may provide some relief by spreading the recovery over several tax years even though the recovery is paid over in one lump sum so there is not risk of nonpayment.

The consideration of tax consequences does not apply strictly to plaintiffs, but defendants as well. Payments may be fully tax deductible, partially deductible, or entirely non-deductible. Consequently, it is easy to see why understanding the applicable tax rules should be a prerequisite to resolving litigation.

Helping Clients Make the Right Tax Choices

In most cases clients are only interested in the bottom line: “How much am I going to get?” This is not a simple question to answer because the amount depends on several factors. However, no consideration is more important than the tax consequences of different types of recoveries.

Whether recovery is because of a jury award or an out of court settlement, the tax rules will apply. This means it’s vital that your law suit is set up initially to minimize the tax liability upon an award. Seeking assistance in this area early will increase the chance of structuring the tax impact to maximize the benefits to litigants. Don’t wait until it’s time to determine the amount of the award to try to create the greatest tax advantage for yourself, because it can often be too late. A tax professional can give you the advice you need early in the process, yielding the most tax benefits down the line.

There are several questions one should ask when determining the taxation of judgment awards and settlements.

  • What claims were originally sued for?
  • First, what recoveries need to be reported?
  • Second, what is the classification of the recovery funds in relation to the original claims sued for?
  • Third, which portions of the settlements were compensatory versus punitive?
  • Fourth, was there a proper allocation of settlement funds among the original claims or was tax law manipulated?
  • Will a structured settlement be utilized?

The answers to these questions are vital in determining tax liability.

Special Tax Circumstances

In terms of settlement and judgments, the most important exception to the general income inclusion provision is for personal physical injuries and physical sickness under Section 104. Under Section 104, if funds are recovered because of a personal physical injury or physical sickness, this portion of the recovery is excludable from gross income.

Conversely, damages received on account of non-physical injury or sickness (such as defamation, age discrimination, housing discrimination, injury to personal or business reputation, et cetera) are not excludable from gross income.

Suing for emotional distress ordinarily results in a recovery that is taxable as it does not constitute a physical injury or physical sickness—unless the income payments are received as a result of emotional distress stemming directly from a physical injury or physical sickness. A change to the IRS rule in 1996 determined that injuries must be physical or visible to be excluded from tax, and emotional distress was specifically excluded in the rule. Additionally, symptoms of emotional distress do not count as physical injuries, so any award based on these symptoms, which may include headaches, will be taxable. However, for example, a persistent stomach ache caused by emotional distress must have a tax free physical injury award aspect to it, such as when the recovery is related to an ulcer, for example.

Clearly, there is incentive to attempt to posture a recovery so that it fits under the §104 tax free recovery umbrella. The government is also well aware of this fact and routinely attacks legal settlements that appear to unjustly avail themselves of tax free treatment.

Understanding the Claims Test (Origin of the Claim Doctrine)

Nonetheless, the most enduring cannon in this area is the claims test, which states that the tax result of a settlement or judgment award should be determined by reference to the underlying claim the lawsuit seeks to redress. Thus, a recovery for back pay is treated in the same manner as salary or wage payments and, therefore, taxable as ordinary income.

In contrast to compensatory damages, Congress has clarified that punitive damages, whether or not related to a claim for damages arising out of physical injury or sickness, are not excludable from gross income. What’s more, if parties to a suit try to allocate more money than is reasonable to nontaxable compensatory rather than to taxable punitive damages, the allocation will not be respected.

Rather than letting the courts or the IRS dictate an allocation in their favor, the better practice is to consult a tax professional from the beginning. If engaged, our firm will determine the proper tax treatment, take a reasonable position on a tax return and defend that return position if necessary even though no guarantees can be made on the inevitable outcome of the audit.awards and settlements tax lawyer

Tax deductibility determination for lawsuit defendants

Another important aspect is the tax effect of lawsuits on defendants. The Internal Revenue Code does not expressly allow deductions for damages or settlement payments. But assuming the requisite business nexus, defendants can deduct settlements or judgments, including legal fees, with little issue. This is in relation to the general business expense provisions of Section 162. However, certain conditions must be met. For example, the payments must be ordinary, necessary, and reasonable.

At the Tax Law Offices of David W. Klasing in Irvine, Los Angeles and across Northern and Southern California, we provide aggressive representation for our clients. We offer more than 20 years of focused experience handling highly complicated tax matters throughout Orange County, California, and surrounding areas. When you select our firms legal services, you gain the benefit of working with an experienced Tax Attorney and CPA for the same price. Our extensive knowledge of state and federal tax codes, regulations and case law can help save you money.

For a reduced rate on an initial consultation, call 800-681-1295 or contact our offices online.

Questions Answered about Awards and Settlements