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Four Tax Considerations in Settling a Legal Dispute: Begin with the End in Mind

Jul 18, 2019

Attorneys and clients frequently ask us about the tax reporting following a settlement or a favorable jury verdict. Proper planning is key for any matters within your control: The goal is not only to recover, but also to preserve, as much compensation as possible for the injured party. Even if you anticipate that your client will be taxed on the entire recovery, recognizing that fact at the outset is important so that you can negotiate with the net recovery in mind.

One: The original complaint or petition is the key in determining whether your client’s settlement proceeds are taxable.

All awards are taxable unless the Internal Revenue Code provides a specific exception. The actual basis for the settlement or jury verdict controls whether the resulting damages are excludable. The complaint should not only set forth the injuries, but specifically seek relief for each of them. Damages are designed to make the injured party whole, repairing the damage that the wrongdoer inflicted. For what purpose did your client receive the money? The answer will determine whether they are excludable from gross income. Some examples:

Purpose of Compensation  Nature of Recovery Tax Effect
Lost Profits Ordinary Income Taxable
Unlawful Discrimination or Wrongful Discharge Wages/Ordinary income Taxable 
Punitive Damages Ordinary Income (except in certain wrongful death cases) Taxable
Replacement of Capital Return of Capital and/or Capital Gain Not Taxable (unless the recovery exceeds tax basis of the investment)
Physical Injuries and Other Damages Derived from the Physical Injuries Compensation for a Physical Loss Not Taxable
Reimbursement for Medical Expenses (not previously deducted on a Form 1040) Compensation for a Financial Loss Stemming from Personal Physical Injuries or Sickness Not Taxable 
Accrued Interest on Court Judgments Interest Income Taxable

Two: If the nature or allocation of the monetary recovery is not evident from the settlement agreement, the Internal Revenue Service can “discern” the payer’s intent after the fact.

Settlements can occur at almost any stage of litigation, both before and after a jury verdict. If the plaintiff’s complaint included multiple categories of damages (taxable and non-taxable claims), the agreement should document which claims the settlement incorporates and in what proportions.

If the case goes to trial and either a judge or jury renders a verdict, their allocation of damages carries greater weight than does a settlement because judges and juries are presumably more objective than are the participants.

Both parties have an interest in an allocation that reflects their agreement. Therefore, it is critical that those ideas are clearly spelled out. For example, the Tax Cuts and Jobs Act of 2017 (TCJA) prohibits a deduction for settlement payments in sexual harassment cases which include a non-disclosure agreement. Without some basis for limiting the non-deductible portion, the deductibility of the entire settlement could be subject to tax.

Even if the parties agree to and allocate the damages, the Service does not necessarily have to accept it if the proposed allocation fails to reflect the true economics of the underlying claims. Nevertheless, the agreement stands a better chance of acceptance if the parties do allocate the damages among the various categories of claims. The worst case scenario is that the Service finds lack of confluence and attempts to discern the payer’s intent after the fact – not a comfortable situation for either the taxpayer or counsel.

Three: In certain situations, your client may be able to deduct attorneys’ fees and court costs.

Prior to the enactment of the TCJA, legal fees and court costs were deductible as a miscellaneous itemized expense subject to the 2% AGI limitation on Schedule A. The TCJA has since eliminated the itemized deduction for legal fees.

Post-TCJA, individual taxpayers may deduct legal fees from taxable income in only very limited circumstances. IRC Sec. 62(a)(21) allows an “above-the-line” deduction -- in other words, a deduction from adjusted gross income -- if the original claim was rooted in unlawful discrimination or any of the other specifically enumerated claims within that subsection of the Code. Those claims include various forms of unlawful discrimination, an act that is unlawful under IRC Sec. 62(e), and many claims arising from an employment relationship.

If the complaint alleges multiple claims, it is not clear whether it is necessary to allocate the legal fees between the qualifying legal fees and other legal fees. As of this date, the Service has not taken a position as to whether, if the litigant prevails on one claim in IRC Sec. 62(a)(21), he or she is permitted to deduct 100% of legal fees or only the proportion pertaining to the unlawful discrimination claim.

Note that the caveat above pertains to individual taxpayers. If your client is a sole proprietor, and the claims arose from that relationship, the client’s attorneys’ fees may still be deductible as trade or business expenses on Schedule C.

Four: The Service is very interested in how your client reports the award on his or her income tax return.

The Service may review the taxpayer’s return for potential errors, including the following

  1. Did your client actually file a return reporting the proceeds?
  2. Were the proceeds reported at gross, rather than net of legal and other fees?
  3. Was there was a proper allocation between compensatory (potentially tax-exempt if for physical injury or sickness) and punitive (taxable) damages?
  4. Was interest reported correctly as income?
  5. If your client deducted the legal fees, were they deducted properly?

The proper reporting of proceeds should match the Form 1099, assuming that the payer issued them. If the taxpayer’s reporting conflicts with the payer’s 1099, the Service may be contacting your client, who, incidentally, bears the burden of proof in an audit.

There are many litigation hurdles to clear before arriving at the finish line with compensation for your client. The income tax on the recovery may seem like a minor concern at the outset, but it will become significant once the client realizes how taxes can diminish the recovery. A little bit of planning can go a long way in preserving your success.

Stay tuned for the related 1099 Reporting Considerations which will appear in a future blog.

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