What Are the Tax Consequences of a Settlement to the Recipient of a Non-Personal Injury Action?

In litigation, any settlements should take into consideration the tax consequences to the client recipient of settlement proceeds. As a litigator, this is something very important to consider for the benefit of the client because the settlement can put the client in a tax bracket over and above what he/she is at, thereby increasing the percentage of tax the client has to pay. Here are the nuts and bolts of the taxability of non-personal injury settlements: all damages/settlements received are taxable as gross income with the exception of damages for emotional distress that are used specifically to pay medical expenses. This article does not address the taxability of personal injury settlements which is treated differently under the Internal Revenue Code ("IRC").

Lost Earnings and Lost Wages

Compensatory Damages received in non-personal injury lawsuits whether pursuant to judgment or settlement are taxable as ordinary income if they compensate the recipient for lost earnings. Estate of Carter v. Commissioner (8^th Cir.1962) 298 F.2d 192. Recoveries in employment contract disputes are generally characterized as ordinary income, just as the compensation would have been characterized under the contract. Stocks v. Commissioner (1992) 98 T.C. 1; Byrne v. Commissioner (1988) 90 T.C. 1000; Glynn v. Commissioner (1981) 76 T.C. 116. Since back pay is a quintessentially contractual measure of damages, any recovery of back wages is taxable, even if paid along with tort-like injuries. Commissioner v. Schleier (1995) 515 U.S.323; United States v. Burke (1992) 504 U.S. 299.

Reimbursement of Legal Fees and Deduction of Legal Fees

Judgment or settlement amounts intended to reimburse a taxpayer for legal fees in non-personal injury cases are generally considered income to the taxpayer. Baylin v.United States (Fed. Cir. 1995) 43 F.3d 1451; Bagley v. Commissioner (1995) 105 T.C. 396; Estate of Gadlow v. Commissioner (1968) 50 T.C. 975; Rev. Rul. 60-14, 1960-1 C.B. 16. Where an attorney is paid under a contingent fee arrangement, the client must include in gross income as a contingent fee. Commissioner v. Bank (S.Ct. Jan. 24, 2005) NO. 03-892 . Under the anticipatory assignment of income doctrine, a taxpayer may not avoid taxation by assigning income to another party. Id.

Legal fees may be deducted as ordinary and necessary business expenses. Whether litigation expenses are deductible business expenses depends on the origin and character of the claim for which the expense incurred and whether the claim bears a sufficient nexus to the taxpayer’s business. US v. Gilmore (1963) 372 US 39. Ordinary and necessary litigation costs generally are deductible when the matter giving rise to the costs is proximately related to a business activity. Woodward v. Commissioner (1970) 397U.S. 572. If indeed the legal fees are qualified as business expense, the effectiveness of the deduction may be substantially limited by the 2 percent floor on miscellaneous itemized deductions under IRC §67 and the alternative minimum tax, under which miscellaneous itemized deductions are completely disallowed.

Emotional Distress Damages in Employment Discrimination/Wrongful Termination Case

Only damages that result from personal injury actions are excluded from gross income. IRC Section 104(a)(2). The exclusion from gross income does not apply to damages received through employment discrimination or defamation actions accompanied by a claim for emotional distress. However, taxpayers can exclude damages received for medical expenses associated with emotional illness (this does not include amounts compensating for emotional distress beyond the medical expenses). IRC § 104(a); Treas. Reg. 1.213-1(g).

Punitive Damages

IRC §104(a)(2) expressly provides that punitive damages are not excluded from income, even though such damages may accompany the award of other damages that are excluded from income.

Article Submitted By: Attorney Pamela Tahim

Comments

[DPS]

What about a civil judgment where plaintiff receives an award that effectively reimburses them for out-of-pocket expenses incurred in reliance of defendant's actions?