Taxation of Settlement Payments
| Publication year | 2019 |
| Pages | 0018 |
Taxation of Settlement Payments
Whether you are a plaintiff, a defendant or counsel for one of the parties, failing to address probable tax consequences before a settlement is finalized can cause major problems. In fact, it is prudent to consider tax implications at each and every stage of the proceedings, all of which can impact the taxability of its ultimate resolution.
BY JULIAN A. FORTUNA AND GERIKA KELLY
As with many other areas of tax law, analyzing the tax consequences of the payment and receipt of settlement funds can become quite complex. Despite a tendency by litigants to avoid contemplating the tax consequences of a dispute until just prior to executing a settlement agreement, such consequences are usually impacted by prior stages in the process and are often material to both the recipient and the payor. A recipient should generally seek to allocate settlement proceeds to claims that produce non-taxable income, return of capital or capital gains (in that order of preference), and try to preserve tax deductions for attorney fees. Conversely, a payor should consider the impact of a proposed allocation on the tax deductibility of the payments as ordinary losses, capital losses or depreciation/ amortization of capital costs, while carefully also considering and satisfying any tax with-holding and reporting obligations. Even more ominous is the tug-of-war between a defendant and a governmental entity. While it is clearly in the defendant's best interest to allocate payments to tax deductible compensatory damages and away from non-deductible fines and penalties, the government's objective will be to allocate payments to fines and penalties in order to generate tax revenue and avoid adverse publicity.[1]
General Principles
Origin, Nature and Substance of Claims A shallow dive into the tax treatment of settlement payments starts with consideration of general factors, such as the origin, nature and substance of the underlying claims, the terms of the settlement agreement and the intent of the parties, particularly the payor.[2] In addition to these factors, the courts have also taken a "substance over form" approach, requiring that an allocation among claims in a settlement agreement will be respected only if entered into by parties in an adversarial context, at arm's length and in good faith.[3] Relevant evidence as to the true nature and substance of the claims and the proper allocation of settlement proceeds among those claims may include: (1) allegations contained in information claims or demand letters; (2) allegations and claims for relief contained in formal complaints; (3) the judgment of a tribunal judge or jury (if the case was tried); (4) records detailing the history of settlement negotiations; (5) the method used to calculate the settlement payments; and (6) the specifics of the settlement agreement, preferably approved by a court.[4]
A shallow dive into the tax treatment of settlement payments starts with consideration of general factors, such as the origin, nature and substance of the underlying claims, the terms of the settlement agreement and the intent of the parties, particularly the payor.
Impact of Classification of Payments on Recipient
Compensation for lost wages, sales, profits, royalties, salaries or similar items are generally taxable to the recipient as ordinary income at tax rates as high as 37 percent.[5] Compensation for the sale, exchange, loss or decline in value of tangible or intangible property may produce a non-taxable return of capital up to tax basis, and then either ordinary income or capital gain, depending upon the type of asset.[6] Capital gains are taxed to individual taxpayers at rates of 0, 15 or 20 percent depending on total taxable income.[7] However, what constitutes compensation for the sale, exchange, loss or decline in value of tangible or intangible property in a litigation context is not always clear.[8] Finally, as discussed in detail below, payments allocable to either (1) workmen's compensation, (2) damages for personal physical injury or physical sickness or (3) damages for wrongful conviction are generally not taxable to the recipient.
Impact of Classification of Payments on Payor
Settlement payments are currently deductible against ordinary income only if they qualify as trade or business expenses or expenses incurred for the production of income.[9] Transfers to certain "designated" or "qualified" liability settlement funds may generate current deductions for accrual basis taxpayers even though claimants may be paid later.[10] However, payments that facilitate or are ancillary to the acquisition or ownership of a capital asset must be capitalized.[11] Any capitalized costs may or may not generate depreciation or amortization tax deductions.[12] Finally, as discussed in detail below, no tax deductions are allowed for payments of fines or penalties to, or at the direction of, a government or governmental entity in relation to the violation of any law or
the investigation or inquiry by such government or entity into the potential violation of any law.[13]
Payments by Employers
Severance Payments
Severance payments to terminated employees (absent allocations to claims for damages) are generally considered wages subject to both income tax and Federal Insurance Contributions Act (FICA) withholding.[14] Under a narrow exception, the Internal Revenue Service (IRS) does not require FICA to be withheld from severance payments tied to the receipt of state unemployment benefits.[15] However, the IRS takes the position that amounts paid for the early termination of an employment contract are wages under the "substitution for ordinary income" doctrine.[16] A recent court decision calls into question this rationale, by holding that the substitution for ordinary income doctrine is not applicable to the right to earn future income.[17] Alternatively, a key employee without an employment contract may seek more favorable treatment by allocating severance payments to the sale of personal goodwill, resulting in capital gain rather than ordinary wage income.[18] Nevertheless, employers should resist such allocations because they would require the employer to capitalize and amortize rather than currently deduct the severance payments.[19]
Other Payments
Payment for "back-pay" under various workers' rights and civil rights statutes are generally considered wages subject to withholding in the year paid.[20] A majority of courts have classified "front pay" as wages, but not all circuits have followed suit.[21] The circuit courts are also split as to whether settlement proceeds in illegal refusal to hire cases are wages.[22] Furthermore, authorities are split concerning whether damages paid for violating the Family and Medical Leave Act constitute wages.[23]
The tax deductibility of certain settlement payments made by an employer is just as fluid. For example, the Tax Cuts and Jobs Act of 2017[24] (TCJA) included a provision disallowing deductions for any settlement, payout or attorney fees related to sexual harassment or sexual abuse if such payments are subject to a nondisclosure agreement.[25] However, the statutory language and legislative history are unclear. Among the unanswered questions are: (1) When is a payment considered "related to" sexual harassment or abuse, and how are those terms defined?; (2) Is the entire settlement payment non-deductible if it only partially relates to sexual harassment or abuse?; and (3) Will a nondisclosure agreement prevent deductibility if it applies only to claims other than sexual harassment or abuse?
Non-Taxable Payments
Workmen's Compensation
Section 104(a)(1) of the Internal Revenue Code (the Code) excludes from taxation "amounts received under workmen's compensation acts as compensation for personal injuries or sickness[.]"[26] In the settlement context, the courts have strictly applied two additional conditions not expressly set forth in the statute: the settlement agreement must be valid under workers' compensation laws and not go beyond the scope of such laws in order for payments thereunder to qualify as non-taxable.[27] Furthermore, the IRS and the courts have declined to extend the applicability of the exclusion to a pension or annuity payment "to the extent that it is determined by reference to the employee's age or length of service, or the employee's prior contributions, even though the employee's retirement is occasioned by an occupational injury or sickness."[28]
Damages for Personal Physical Injury, Physical Sickness or Emotional Distress Damages (other than punitive damages) received "on account of personal physical injuries or physical sickness" and "emotional distress" that is "attributable to a physical injury or physical sickness" are not taxable.[29] If the origin of a claim is physical injury or physical sickness, then all damages (other than punitive) that flow therefrom (e.g., loss of consortium) are non-taxable whether or not the recipient of the damages is the injured party.[30] In cases involving qualified structured settlements (i.e., one to which the Section 104(a)(2) exclusion applies), the IRS has ruled that the sale of structured settlement rights does not result in the realization of income to the plaintiff, even though a portion of the payment for the settlement rights reflects interest.[31]
Before a recipient of settlement funds can take advantage of this favorable tax treatment, the recipient must be certain that the particular damage claim to which the settlement proceeds are allocable qualifies as "physical injury or sickness." IRS rulings have attempted to define "physical injuries."[32] Damages received for emotional distress, that are not "attributable to" physical...
To continue reading
Request your trial