SC Lawyer, January 2006, #2. Traversing the Swamp: Understanding the Tax Implications of Settlements and Awards in Employment-Related Litigation.

AuthorBy Preston R. Burch and James H. Fowles III

South Carolina Lawyer


SC Lawyer, January 2006, #2.

Traversing the Swamp: Understanding the Tax Implications of Settlements and Awards in Employment-Related Litigation

South Carolina LawyerJanuary 2006Traversing the Swamp: Understanding the Tax Implications of Settlements and Awards in Employment-Related LitigationBy Preston R. Burch and James H. Fowles IIIWading through litigation is like crossing a bog, particularly in an employment dispute. Lawyers are used to it; clients are not. Near journey's end, many attorneys suddenly realize what their clients knew the entire time. Unknown perils live in the swamp, one such peril being the proper tax treatment of a settlement or award. If the tax structure of a settlement or award is not properly crafted and documented, a client's confusion or, worse yet, scrutiny from the Internal Revenue Service (IRS), stands between the parties and journey's end. What follows is a "map through the swamp" for several tax issues in employment-related cases.

The basic questions

The damages available to any plaintiff fall generally into different categories: equitable, compensatory, punitive and liquidated damages; attorneys' fees; interest; and other various types. Compensatory damages appear as lost wages, lost opportunities, emotional distress, physical personal injury, medical bills, etc. Basic tax questions apply to every category: (1) Is the damage component gross income to the plaintiff? (2) If gross income, is it "wages" subject to employment taxes? (3) What reporting requirements exist for any payment? (4) How can the parties allocate the settlement or award funds in a manner that will withstand IRS scrutiny? With respect to this last question, parties often believe that a judicial award (as opposed to a settlement) provides greater protection. This belief is misplaced because no legal differences exist in the tax principles at play in either an award or a settlement. See Longino v. Commissioner, 32 T.C. 904 (1959).

When addressing these questions, the parties must remember the perspective of the judiciary and the IRS. Starting from the premise that gross income means all income from whatever source derived, the U.S. Supreme Court has repeatedly emphasized the "sweeping scope" of the premise, Rudolph v. United States, 370 U.S. 269 (1962), as well as the rule that deductions are allowed only by "legislative grace; and only as there is a clear provision therefore can any particular deduction be allowed." New Colonial Ice Co. v. Helvering, 292 U.S. 435 (1934). The U.S. Supreme Court has further recognized the "broad phraseology" of the statute defining gross income in order to exert "the full measure of its taxing power." Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 430-431 (1955). Other courts also view the concept of "wages" subject to employment taxes as a category of income broadly defined. See Hemelt v. United States, 122 F.3d 204, 209-211 (4th Cir. 1997).

Are the damages income?

Practitioners generally understand that damages associated with wages in an employment related suit are "income" subject to tax. Most attorneys also understand that if the damages at issue are proximately caused by a personal physical injury, they are excludable from gross income. Many questions linger, though, with respect to emotional distress damages, punitive damages and attorneys' fees. Several of these major issues have been resolved in recent years, either through amendments to the tax code or though interpretations of the same.

Prior to 1996, Section 104 of the tax code excluded from income any "amount of any damages received . . . on account of personal injuries or sickness." Construing this former version of Section 104(a)(2), the U.S. Supreme Court said (1) that the taxpayer must demonstrate the underlying cause of action giving rise to the recovery was based on tort or tort type rights and (2) that the taxpayer must show the damages were received "on account of personal injuries or sickness." Commissioner v. Schleier, 515 U.S. 323 (1995). Based on these standards, punitive damages that arose from a personal injury claim, as well as any related pain and suffering award, often were not included in gross income.

The treatment of these damages changed drastically in 1996 when Congress narrowed Section 104(a)(2). The personal injury exclusion from gross income is now limited to cases of personal physical injuries or physical sickness. Further, Section 104(a)(2) indicates that punitive damages, whether for personal physical injury or not, are not excluded...

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