Tax Consequences of Settlement Awards for Plaintiffs and Attorneys

Published Categorized as Federal Income Tax, Lawsuit Awards, Tax
Taxation Of Settlement Agreements For Plaintiffs Attorneys
Taxation Of Settlement Agreements For Plaintiffs Attorneys

When an individual receives a settlement award, the tax consequences of that award can vary depending on how it is structured. There are several tax planning opportunities available for individuals who receive settlement awards, but in most cases, the tax consequences are fairly standard. The case of Lindsey v. Commissioner, 422 F.3d 684 (8th Cir. 2005), provides an example of how settlement awards are typically taxed.

Facts & Procedural History

The taxpayer was the CEO of Empire Gas Corporation. He received $2 million as part of a final corporate settlement with Empire Gas Corporation. Lindsey claimed that the payment was in settlement of his claims for tortious interference with contracts, personal injury, emotional distress, humiliation, and embarrassment resulting from the termination of the Synergy Acquisition documents.

When the taxpayer and his wife filed their 1996 federal tax return in January 1998, they did not include the $2 million settlement in their gross income and reported a tax liability of zero.

The IRS issued a Notice of Deficiency in the amount of $729,749 and penalties exceeding $315,000 for the 1996 and 1997 tax years. The taxpayers a petition for redetermination of the deficiencies and penalties in the U.S. Tax Court.

The question was whether the settlement payment was excluded under Section 104.

Including the Settlement in Income

Section 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 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. They even include cases for loss of consortium and being born with a medical condition, repeated injury suits. The cases often turn on the evidence presented.

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.

That is what we had in this case. The court noted that some of the claims specified in the Termination Agreement were based in tort, so the taxpayers satisfy the tort or tort-like prong. The court went on to say that the taxpayers had to establish “a direct causal link” between the damages and the personal injuries or physical sickness sustained.  The evidence included testimony from the taxpayer’s physician that the taxpayer suffered from hypertension and stress-related symptoms, including periodic impotency, insomnia, fatigue, occasional indigestion, and urinary incontinence. 

The tax court, and now the appeals court, concluded that these health symptoms relate to emotional distress, and not to physical sickness. As such, there was no direct causal link between damages and physical sickness.

How to Handle Attorneys Fees

While not at issue in this case, the tax treatment of attorneys fees is also usually at issue in cases like this. 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 fewer attorneys fees.  Rather, the settlement award is reported in full as income and the attorney’s 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.  

The Takeaway

This case illustrates how settlement awards are typically taxed and the importance of properly reporting them on tax returns. Taxpayers must include settlement awards as income unless the payment was made in response to physical injuries or sickness. In addition, attorneys’ fees paid for prosecuting the claim cannot be netted against the settlement award but must be deducted as an itemized deduction, which may be subject to limitations. Properly handling the tax consequences of settlement awards is essential to avoid additional taxes and penalties.

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