Allocating settlement proceeds in employment cases.

• Author: Monroe, Tracy J.

After the Small Business Job Protection Act of 1996 (SBJPA) significantly changed the taxability of settlement proceeds in personal injury cases, many practitioners thought that the opportunities to reduce the tax burden on settlement proceeds had been eliminated. However, careful examination of the settlement allocation may increase the after-tax proceeds available and employment disputes may allow reclassification and exclusion from employment tax.

Background

Under Sec. 104(a), settlement proceeds received on account of physical personal injury or sickness are excludible from income. Before the SBJPA, this exclusion also included emotional distress proceeds; thus, many wrongful termination, age discrimination and breach of contract cases included an emotional distress allocation. Because the Sec. 104(a) exclusion currently applies only to compensatory damages for actual physical personal injury or sickness, many settlement agreements for the types of cases noted above allocate the entire settlement proceeds to wages, subjecting it not only to ordinary income tax, but also to employment taxes (e.g., FICA, FUTA and state unemployment tax (SUTA)).

Settlement agreements may not mention the allocation of the settlement proceeds, but if they do, the tax adviser should scrutinize the wording. Generally, when the settlement agreement expressly allocates the settlement proceeds among various claims, the allocation is binding for tax purposes. However, to be respected, such allocation must be determined in good faith and at arm's length. For example, an amount paid to settle a lost-profits claim is currently deductible, but is ordinary income to the recipient. If the same amount is allocated as harm to a capital asset, it may be a capital gain to the recipient, but nondeductible by the payer. In some cases, the payer may be indifferent from a tax standpoint as to how the recipient allocates amounts in the settlement agreement (e.g., a tax-exempt entity). In such cases, the IRS and the courts are not bound by the allocations and may examine the claim's true nature and substance.

If the payer is engaged in a trade or business, any payments under a judgment or settlement in connection with such trade or business are deductible if Sec. 162 is met. However, Sec. 162(f) bars a deduction for fines or penalties paid to a government for the violation of any law. Under Sec. 162(g), the payer cannot deduct two thirds (i.e., the penalty portion) of treble...