Post Trump Tax Reform, How Legal Settlements Are Taxed
| Publication year | 2018 |
| Author | Robert W. Wood |
Robert W. Wood
Robert W. Wood is a tax lawyer with www.WoodLLP.com, and the author of numerous tax books, including Taxation of Damage Awards & Settlement Payments (www.TaxInstitute.com). This discussion is not intended as legal advice.
Lawyers and clients resolve disputes all the time, usually with an exchange of money and a release. One of the first questions plaintiffs ask their attorneys is whether the payments they receive will be taxable. The answer to that question can vary enormously, depending on how you were damaged, how the case was resolved, how the checks and IRS Forms 1099 were issued, and other variables.
Last year, the Business Law News published an article by the author summarizing the tax rules that applied in this common situation.1 Some of those tax rules changed with the major tax bill passed in December 2017,2 however. This article updates that earlier article to reflect the changes, which impact the tax treatment of attorney fees in a variety of cases and add special rules for sexual harassment and abuse cases.
In 2017, the author identified ten rules that lawyers and their clients should know about the taxation of settlements. This update restates the first seven rules, which were not affected by the changes, both to provide context and for ease of reference. Original rules eight through ten have been rewritten in their entirety, and a new rule has been added to address the special treatment accorded to sexual harassment and abuse awards by the 2017 Tax Act.
The same tax rules apply whether you are paid to settle a case or win a lawsuit judgment, or even if your dispute only reached the letter-writing phase. Despite the similarities, though, you'll almost always have more flexibility to reduce taxes if a case settles rather than goes to judgment.
If you are audited, you'll need to show what the case was about and what you were seeking in your claims. Consider the settlement agreement, the complaint, the checks issued to resolve the case, IRS Forms 1099 (or W-2), etc. You can influence how your recovery is taxed by how you deal with these issues.
Settlements and judgments are taxed according to the item for which the plaintiff was seeking recovery (the "origin of the claim").3 If you're suing a competing business for lost profits, a settlement will be lost profits, taxed as ordinary income. If you get laid off at work and sue for discrimination seeking wages and severance, you'll be taxed as receiving wages.
In fact, your former employer will probably withhold income and employment taxes on all (or part of) your settlement. That is so even if you no longer work there, even if you quit or were fired years ago. On the other hand, if you sue for damage to your condominium by a negligent building contractor, your damages usually will not be income.
Instead, the recovery may be treated as a reduction in your purchase price of the condominium. That favorable rule means you might have no tax to pay on the money you collect. However, these rules are full of exceptions and nuances, so be careful. Perhaps the biggest exception of all applies to recoveries for personal physical injuries (see point three following).
This is a really important rule, and one that causes almost unending confusion with lawyers and their clients. If you sue for personal physical injuries like a slip and fall or car accident, your compensatory damages should be tax-free. That may seem odd, since you may be seeking lost wages because you couldn't work after your injuries.
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But a specific section of the tax code—§ 104 (26 U.S.C. § 104)—shields damages for personal physical injuries and physical sickness. Note the "physical" requirement. Before 1996, "personal" injury damages were tax-free. That meant emotional distress, defamation, and many other legal injuries also produced tax-free recoveries. That changed with the 1996 amendments to the key tax code provision.4
Since then, your injury must be "physical" to give rise to tax-free money. Unfortunately, neither the IRS nor Congress has made clear what that means. The IRS has generally said that you must have visible harm (cuts or bruises) for your injuries to be "physical."5 This observable bodily harm standard generally means that if you sue for intentional infliction of emotional distress, your recovery is taxed.
If you sue your employer for sexual harassment involving rude comments or even fondling, that is not physical enough for the IRS. But some courts have disagreed. The Tax Court, in particular, has allowed some employment lawsuits complete or partial tax-free treatment, where the employee had physical sickness from the employer's conduct or the exacerbation of a preexisting illness.6
Thus, standards are getting a little easier. However, taxpayers routinely argue in U.S. Tax Court that their damages are sufficiently physical to be tax-free. Unfortunately, the IRS usually wins these cases.7 In many cases, a tax-savvy settlement agreement could have improved the plaintiff's tax chances.
The tax law draws a distinction between the money you receive for physical symptoms of emotional distress (like headaches and stomachaches) and personal physical injuries or physical sickness.8 Here again, these lines are not clear. For example, if in settling an employment dispute you receive $50,000 extra because...
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