What to Know About Taxation of Settlements and Judgments

What You Must Know About Taxation of Settlements and Judgments

Taxation of Settlements and Judgments

When it comes to settlements and judgments, oftentimes — to the chagrin of the U.S. Taxpayer — there are U.S. tax implications for being part of a settlement or judgment. Various Internal Revenue Code sections impact how settlements and judgments are taxed by the U.S. Government. In general, Section 61 (Gross Income Defined) is the primary code section used to assess the taxation of income

• • “Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items…”

When analyzing how certain categories of income are taxed, Taxpayers go from general to specific. Thus, the general rule is that all income is taxable, and then if there are specific exceptions, exclusions, or limitations that may apply to the primary rule that income is taxable. Let’s walk through the basic tax implications of settlements and judgments to give you a general introductory idea of how the tax works. Noting, that for taxpayers who prefer a much more in-depth analysis, the Internal Revenue Service provides a good summary and a road map to help you understand if your settlement or judgment may be taxable.

61. Gross income defined

(a) General definition

• • • Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:

      • (1) Compensation for services, including fees, commissions, fringe benefits, and similar items;

      • (2) Gross income derived from business;

      • (3) Gains derived from dealings in property;

      • (4) Interest;

      • (5) Rents;

      • (6) Royalties;

      • (7) Dividends;

      • (8) Annuities;

      • (9) Income from life insurance and endowment contracts;

      • (10) Pensions;

      • (11) Income from discharge of indebtedness;

      • (12) Distributive share of partnership gross income;

      • (13) Income in respect of a decedent; and

      • (14) Income from an interest in an estate or trust.

§104. Compensation for injuries or sickness

• (a) In general

  • Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include–

    • (1) amounts received under workmen’s compensation acts as compensation for personal injuries or sickness;

    • (2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness;

    • (3) amounts received through accident or health insurance (or through an arrangement having the effect of accident or health insurance) for personal injuries or sickness (other than amounts received by an employee, to the extent such amounts

      • (A) are attributable to contributions by the employer which were not includible in the gross income of the employee,

      • or (B) are paid by the employer);

  • (4) amounts received as a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country or in the Coast and Geodetic Survey or the Public Health Service, or as a disability annuity payable under the provisions of section 808 of the Foreign Service Act of 1980;

  • (5) amounts received by an individual as disability income attributable to injuries incurred as a direct result of a terroristic or military action (as defined in section 692(c)(2)); and

  • (6) amounts received pursuant to-

    • (A) section 1201 of the Omnibus Crime Control and Safe Streets Act of 1968 (42 U.S.C. 3796); ¹ or

    • (B) a program established under the laws of any State which provides monetary compensation for surviving dependents of a public safety officer who has died as the direct and proximate result of a personal injury sustained in the line of duty, except that subparagraph (B) shall not apply to any amounts that would have been payable if death of the public safety officer had occurred other than as the direct and proximate result of a personal injury sustained in the line of duty.

      • For purposes of paragraph (3), in the case of an individual who is, or has been, an employee within the meaning of section 401(c)(1) (relating to self-employed individuals), contributions made on behalf of such individual while he was such an employee to a trust described in section 401(a) which is exempt from tax under section 501(a), or under a plan described in section 403(a), shall, to the extent allowed as deductions under section 404, be treated as contributions by the employer which were not includible in the gross income of the employee. For purposes of paragraph (2), emotional distress shall not be treated as a physical injury or physical sickness. The preceding sentence shall not apply to an amount of damages not in excess of the amount paid for medical care (described in subparagraph (A) or (B) of section 213(d)(1)) attributable to emotional distress.

IRS Guidance

The IRS provides the following guidance on matters involving the taxation of settlements and judgments (reproduced below):

Resources (Court Cases, Chief Counsel Advice, Revenue Rulings, Internal Resources)

• • • CC PMTA 2009-035 – October 22, 2008  Income and Employment Tax Consequences and Proper Reporting of Employment-Related Judgments and Settlements

    • Publication 4345, Settlements – Taxability  This publication will be used to educate taxpayers of tax implications when they receive a settlement check (award) from a class action lawsuit.

    • Rev. Rul. 85-97 – The entire amount received by an individual in settlement of a suit for personal injuries sustained in an accident, including the portion of the amount allocable to the claim for lost wages, is excludable from the individual’s gross income. Rev. Rul. 61-1 amplified.

    • Rev. Rul. 96-65 – Under current Section 104(a)(2) of the Code, back pay and damages for emotional distress received to satisfy a claim for disparate treatment employment discrimination under Title VII of the 1964 Civil Rights Act are not excludable from gross income. Under former Section 104(a)(2), back pay received to satisfy such a claim was not excludable from gross income, but damages received for emotional distress are excludable. Rev. Rul. 72-342, 84-92, and 93-88 obsoleted. Notice 95-45 superseded. Rev. Proc. 96-3 modified.

Analysis

• • • “Awards and settlements can be divided into two distinct groups to determine whether the payments are taxable or non-taxable. The first group includes claims relating to physical injuries, and the second group is for claims relating to non-physical injuries. Within these two groups, the claims usually fall into three categories:

1. 1. 1. 1. 1. Actual damages resulting from physical or non-physical injury;

            2. Emotional distress damages arising from the actual physical or non-physical injury; and

            3. Punitive damages

• • • Prior to August 21, 1996, IRC Section 104(a)(2) did not contain the word “physical” with regard to personal injuries or sickness. The Code was amended (SBJPA, PL 104-188) to exclude from gross income “the amount of any damages (other than punitive) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness”.

      • The Service has consistently held that compensatory damages, including lost wages, received on account of a personal physical injury are excludable from gross income with the exception of punitive damages. Rev. Rul. 85-97 and also see Commissioner v. Schleier, 515 U.S. 323, 329-30 (1995).

    • Damages received for non-physical injury such as emotional distress, defamation and humiliation, although generally includable in gross income, are not subject to Federal employment taxes.

    • Emotional distress recovery must be on account of (attributed to) personal physical injuries or sickness unless the amount is for reimbursement of actual medical expenses related to emotional distress that was not previously deducted under IRC Section 213. See Emerson v, Comr., T.C. Memo 2003-82 & Witcher v. Comr., T.C. Memo 2002-292.

    • As a result of the amendment in 1996, mental and emotional distress arising from non-physical injuries are only excludible from gross income under IRC Section104(a)(2) only if received on account of physical injury or physical sickness.

    • Punitive damages are not excludable from gross income, with one exception. The exception applies to damages awarded for wrongful death, where under state law, the state statute provides only for punitive damages in wrongful death claims. In these cases, refer to IRC Section 104(c) which allows the exclusion of punitive damages. Burford v. United States, 642 F. Supp. 635 (N.D. Ala. 1986).

    • Employment-related lawsuits may arise from wrongful discharge or failure to honor contract obligations. Damages received to compensate for economic loss, for example lost wages, business income and benefits, are not excludable form gross income unless a personal physical injury caused such loss.

    • Discrimination suits for age, race, gender, religion, or disability can generate compensatory, contractual and punitive awards, none of which are excludible under IRC Section104(a)(2).

    • As a general rule, dismissal pay, severance pay, or other payments for involuntary termination of employment are wages for federal employment tax purposes.

    • The General Instructions for Certain Information Returns provides that for information return reporting purposes, a payment made on behalf of a claimant is considered a distribution to the claimant and is subject to information reporting requirements. Consequently, defendants issuing a settlement payment or insurance companies issuing a settlement payment are required to issue a Form 1099 unless the settlement qualifies for one of the tax exceptions.

    • In some cases, a tax provision in the settlement agreement characterizing the payment can result in their exclusion from taxable income. The IRS is reluctant to override the intent of the parties. If the settlement agreement is silent as to whether the damages are taxable, the IRS will look to the intent of the payor to characterize the payments and determine the Form 1099 reporting requirements.

    • Treatment of Payments to Attorneys – IRC 6041 and 6045 state that when a payor makes a payment to an attorney for an award of attorney’s fees in a settlement awarding a payment that is includable in the plaintiff income, the payor must report the attorney’s fees on separate information returns with the attorney and the plaintiff as payees. Therefore, Forms 1099-MISC and Forms W-2, as appropriate, must be filed and furnished with the plaintiff and the attorney as payee when attorney’s fees are paid pursuant to a settlement agreement that provides for payments includable in the claimant’s income, even though only one check may be issued for the attorney’s fees.”

Issue Indicators or Audit Tips

• • • Research public sources that would indicate that the taxpayer has been party to suits or claims.

    • Interview the taxpayer to determine whether the taxpayer provided any type of settlement payment to any of their employees (past or present).

Review court documents or relevant documents to:

• • • Determine the nature of the claim and the character of the payment.

    • Determine whether the payment, in whole or in part, is INCOME to the recipient.

    • Determine whether the payment, in whole or in part, is WAGES.

    • Determine whether the taxpayer has a reporting requirement, and if so, whether form required is a 1099 or W-2.

      • Request documentation of how the taxpayer reported the payment and whether the appropriate employment taxes were paid. Request copies of the original petition, complaint or claim filed showing grounds for the lawsuit and the lawsuit settlement agreement.

Review the original petition, complaint or claim and lawsuit agreement for:

• • • Clear characterization of payments

    • Settlement checks or a schedule of payments

    • Documentation showing the amount of legal fees paid, including any written fee agreements

    • Disbursement schedule or a clear statement of how the funds were disbursed

    • Documentation of letters or statements that address the taxation of the settlement proceeds.

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