Settlement awards can be structured in a number of different ways. This presents a number of tax planning opportunities. But for the typical settlement award, the tax consequences are somewhat standard.
Including the Settlement in Income
One of the tax issues for settlement awards is whether the award can be excluded from the clients income. Sec. 104 provides one method for excluding settlement awards.
Section 104 allows clients to exclude income that is received on account of physical injury or sickness. There have been several court cases, even U.S. Supreme Court cases, that address this exclusion. Congress has even responded to these court cases by amending the Code a few times.
Sec. 104(a)(2) excludes:
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
In its current form, Sec. 104(a)(2) focuses on personal physical injuries and physical sickness. One has to look to the court cases to determine what counts as a physical injury or sickness. The court cases run the gamut from actual physical injuries to emotional distress to mental effects, such as depression, stemming from physical injuries.
The Origin of the Claim
Whether an award is paid for physical injuries or sickness is generally established by the “origin of the claim.” Whether tort rights or tort type rights are involved is based on state law and requires an examination of the nature of the underlying claim.
This means that the courts look to the underlying pleadings in the court case to see what the claims are for. Since most plaintiffs attorneys include all possible causes of action in their pleadings, it may be difficult to later argue that the award is only for physical injuries or sickness.
Simply mentioning a physical injury in the initial pleading is not enough to qualify for this tax exemption. Likewise, simply stating in the settlement agreement that the agreement is for the release of the right to sue, to avoid the expense of trial, or to settle all claims is generally insufficient. The settlement agreement must state that the settlement was made solely to compensate the recipient for his or her personal physical injury–even if the settlement is partially for emotional and physical injuries.
How to Handle Attorneys Fees
Many settlement agreements are paid over to attorneys who prosecute the claims. This may include contingent payments or hourly charges paid to attorneys.
Taxpayers generally cannot report the net settlement award less attorneys fees. Rather, the settlement award is reported in full as income and the attorneys fees are deducted as an itemized deduction.
This is important for two reasons. First, the deduction may be limited as it is subject to the 2% floor. Second, by including the income in full and then the deduction, the client may trigger an alternative minimum tax liability.
These issues can significantly increase the amount of tax that is due on the settlement award.