The Taxation of Tort Damage Awards and Settlements: When Recovering More for a Client May Result in Less
| Publication year | 2009 |
| Pages | 21 |
| Citation | Vol. 78 No. 6 Pg. 21 |
The Taxation of Tort Damage Awards and Settlements: When Recovering More for a Client May Result in Less
By Susan A. Berson
I. Introduction
Most clients never think about the tax consequences of a win or a settlement. For their lawyers who do, analysis of whether a recovery is taxable has become more complicated through Congress’ and the U.S. Supreme Court’s continual tinkering with tax laws. This article provides a step-by-step guide for determining whether an individual who receives a recovery[1] is taxable and should help practitioners spot potential problems that may require tax planning to maximize the recoveries they achieve for their clients.
First Step: Everything is included in gross income,[2] unless an exception applies[3]
Under the Internal Revenue Code, taxability of income is the rule, exemption from tax the exception. If the cause of action that forms the basis of the recovery satisfies one of the exceptions outlined in Sections 104(a) (1) or (2), the recovery (or the exempt portion thereof) is not included in the client's gross income and is not taxable. If no exception applies, however, the recovery is taxable.
Second Step: Is the recovery on account of personal physical injuries or physical sickness?
Before we move to complexities, two simple rules may be mentioned. 1) Damages that are punitive in nature, and therefore by definition noncompensatory, will generally be taxable. 2) Damages that are compensatory, but arise from no physical injury or physical sickness, will generally be tax-able.[4] However, even if the recovery constitutes compensation for physical injury or physical sickness, additional analysis of the underlying claims will be necessary to determine the tax consequences.[5]
Personal injury recoveries
The basic exclusion for certain personal injury awards is found in § 104(a)(2), which provides that gross income does not include "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 injuries or physical sickness."[6] Before a recovery can fall under this exclusion, the taxpayer must demonstrate that (1) the underlying cause of action giving rise to the recovery is "based upon tort or tort-type rights" and (2) the damages were received "on account of personal injuries or sickness."[7] State law controls for purposes of determining whether a tort-type injury exists.[8] The requirement that damages be from "personal physical injuries or physical sickness" means that, if an action has its origin in a physical injury or physical sickness, then all damages (other than punitive)[9] that flow from the action are treated as damages received on account of personal physical injuries or physical sickness, whether the physically injured or sick person is the one receiving the settlement or award.[10] Moreover, if a tortuous act causes physical injuries,[11] which in turn cause other damages such as lost wages or pain and suffering, then all of the damages will be considered "on account of" physical injury.[12]
Emotional distress recoveries
Confusion often surrounds how the tax code treats compensation for emotional distress. This is because emotional distress is not technically considered a physical injury or physical sickness.[13] Nevertheless, emotional distress damages arising out of a physical injury or physical sickness are still excluded from the client's income. Because all damages received on account of physical injury or physical sickness are excludable from gross income, any damages received on a claim of emotional distress that are attributable to physical injury or physical sickness is excludable.[14]
Workers' compensation claims
Generally, amounts received by employees[15] on account of personal injuries or sickness incurred in the course of employment (i.e., occupational injuries), whether under a workmen's compensation act or similar statute, are excluded from gross income.[16] Yet this exclusion does not apply to a retirement pension or annuity to the extent it is determined by reference to the employee's age or length of service, even if the employee's retirement is necessitated by an occupational injury. Also, an exclusion under a workers' compensation law is limited to the amount of recovery allowed in the applicable statute.[17]
Age discrimination recoveries
Age discrimination recoveries are generally not excludable.[18] Age claims commonly fail to satisfy the second prong of the "Schleier test," that is, plaintiffs are typically unable to show that any part of the proceeds related to a personal injury.[19]
Schleier v. Commissioner[20] is an important case because it provided courts with definitive guidance before Congress took legislative action in 1996, with the passage of the Small Business Jobs Protection Act. Specifically, in Schleier,[21] the Supreme Court had decided that for the § 104(a)(2) exclusion to apply, a recovery must satisfy two distinct requirements: (1) the amount must have been received in an action based upon tort or tort-type rights; and (2) it must have been received "on account of personal injuries or sickness." This became known as the Schleier test. At length, the Court's opinion discusses the requirement that in order to satisfy the "on account of a personal injury or sickness" criterion of (pre-1996) § 104(a2), there must be a direct link between the injury and the recovery. Thus, the two-part test of Schleier was born.
After the Schleier decision's two-part test was handed down, Congress enacted the Small Business Job Protection Act of 1996. In essence, this legislation incorporated the Schleier test into § 104(a)(2).
Racial discrimination recoveries
As a rule, recoveries for claims arising under racial discrimination statutes are included in gross income. As with age discrimination claims, racial discrimination plaintiffs ordinarily cannot show that the recovery was paid on account of physical injuries or physical sickness.[22]
Attorney's fees [23]
After paying legal fees, a plaintiff who must include the entire damage award as taxable income sometimes ends up having little or no money left.[24] Do not assume that the client will be able to deduct the attorneys' fees paid. Normally, attorney's fees can be considered a miscellaneous deduction for taxpayers, subject to a 2 percent floor; that is, such deductions may be claimed only when they exceed 2 percent of the taxpayer's adjusted gross income (which, for most taxpayers, is equal to their gross income). To the extent the taxpayer's recovery is taxable, the taxpayer's income increases, and the level of the 2 percent deductibility threshold also increases. This can eliminate any benefit that the taxpayer would otherwise get from later deducting the attorney's fees.[25] Despite the seeming unfairness, amounts for attorney's fees and costs included in damage awards based on nonphysical injuries or sickness are not excluded from income.[26]
Alternative Minimum Tax (AMT)
Because of a hole in current legislation, plaintiffs in non-civil rights type claims, such as defamation, do not escape the AMT provisions if they are successful in cases involving contingent attorneys' fees.[27]
Third Step: Interest, an often overlooked component
As a general rule, amounts awarded as interest must be included in taxable income, regardless of the underlying cause of action.[28] Unfortunately, practitioners often overlook this, especially when a case is settled following the entry of a judgment for the plaintiff that includes an award of interest.[29] A settlement that states that "no interest" will be payable is insufficient, because case law suggests that the Internal Revenue Service (IRS) would require the client to include at least a pro rata amount of interest, in proportion to the other elements of the judgment that the client was initially awarded.[30]
A practical suggestion: Case law implies that, if the parties stipulate to a moderate amount of prejudgment interest from a specific date forward, it will be more difficult for an IRS challenge to succeed. When this is done, it is important for the interest to be reported separately to the taxpayer on a Form 1099-INT, rather than lumped in with the rest of a recovery.
Fourth Step: Allocation of award between...
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