Lawyers and clients resolve disputes all the time, usually with an exchange of money and a release. There are always tax considerations, and some of these rules changed with the passage of the Tax Cuts and Jobs Act1 in December 2017. The tax changes impact the treatment of attorney fees in a variety of cases, as well as sexual harassment and abuse cases.
Lawyers and their clients should know the basics and a few trouble spots. The tax treatment can vary enormously, depending on how you were damaged, how the case was resolved, how checks and IRS Forms 1099 are issued, etc.
1. Settlements and Judgments Are Taxed the Same
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.
2. Taxes Depend on the "Origin of the Claim"
Settlements and judgments are taxed according to the item for which the plaintiff was seeking recovery (the "origin of the claim").2 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 3).
3. Some Recoveries Are Tax-Free
This important rule causes almost unending confusion among lawyers and 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.
But a specific section (26 U.S.C. § 104) of the tax code 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 in 1996.3
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."4 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.5
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.6 In many cases, a tax-savvy settlement agreement can improve the plaintiff's tax chances.
4. Emotional Distress Symptoms Are Not Physical
The tax law draws a distinction between money for physical symptoms of emotional distress (like headaches and stomachaches) and personal physical injuries or physical sickness.7 Here again, these lines are not clear. For example, if in settling an employment dispute you receive $50,000 extra because your employer gave you an ulcer, is an ulcer physical or is it merely a symptom of your emotional distress?
Many plaintiffs end up taking aggressive positions on their tax returns, claiming that damages of this nature are tax-free. But that can be a losing battle if the defendant issues an IRS Form 1099 for the entire settlement. Getting an agreement with the defendant about the tax issues can help. Otherwise, you might end up surprised with Forms 1099 you receive the year after your case settles. At that point, you will not have a choice about reporting the payments on your tax return.
5. Medical Expenses Are Tax-Free
Even if your injuries are purely emotional, payments for medical expenses are tax-free, and what constitutes "medical expenses" is surprisingly liberal.8 For example, payments to a psychiatrist or counselor qualify, as do payments to a chiropractor or physical therapist. Many nontraditional treatments count, too.
However, if you have previously deducted the medical expenses and are reimbursed when your suit settles in a subsequent year, you may have to pay tax on these items. The "tax benefit" rule9 says that if you previously claimed a deduction for an amount that produced a tax benefit (meaning it reduced the amount of tax you paid), you must pay tax on that amount if you recover it in a subsequent year. Conversely, if you deducted an amount in a previous year, and that deduction produced no tax benefit to you, then you can exclude the recovery of that amount in a later year from your gross income.10
6. Allocating Damages Can Save Taxes
Most legal disputes involve multiple issues. You might claim that the defendant kept your laptop, frittered away your trust fund, undercompensated you, failed to reimburse you for a business trip, or other items. In fact, even if your dispute relates to one course of conduct, there is a good chance the total settlement amount will involve several types of consideration.
It is usually best for plaintiff and defendant to try to agree on what is being paid and its tax treatment. Such agreements are not binding on the IRS or the courts in later tax disputes, but they are rarely ignored. As a practical matter, what the parties put down in the agreement is often followed. And in the real world, there are usually multiple categories of damages.
For all of these reasons, it is more realistic - and more likely to be respected by the IRS and other taxing authorities - if you divide up the total and allocate it across multiple categories. If you are settling an employment suit, there might be some wages (with withholding of taxes and reported on a Form W-2); some nonwage emotional distress damages (taxable, but not wages, so reported on a Form 1099); some reimbursed business expenses (usually nontaxable, unless the employee had deducted them); some pension or fringe benefit payments (usually nontaxable); and so on. There may even be some payment allocable to personal physical injuries or physical sickness (nontaxable, so no Form 1099), although this subject is controversial (see points 3 and 4 above).
7. Capital Gain Instead of Ordinary Income
Outside the realm of suits for personal physical injuries or physical sickness, just about everything is income. However, that does not answer the question of how it will be taxed. If your suit is about damage to your house or your factory, the resulting settlement may be treated as capital gain. Long term capital gain is taxed at a lower rate (15 percent or 20 percent, not 39.6 percent), so it is much better than ordinary income.
Apart from the tax rate preference, your tax basis may be relevant too. This is generally your original purchase price, increased by any improvements you have made, and decreased by depreciation, if any. In some cases, your settlement may be treated as a recovery of basis, not income.
A good example would be harm to a capital asset, such as your house or your factory. If the defendant damaged it and you collect damages, you may be able to simply reduce your basis rather than reporting gain. Some settlements are treated like sales, so again, you may be able to claim your basis.11 In fact, there are many circumstances in which the ordinary income versus capital distinction can be raised, so be sensitive to it. For example, some patent cases can produce capital gain, not ordinary income.12 The tax rate spread can be nearly 20 percent.
8. Deducting Attorney Fees Is Tricky
This area has major changes under the Trump tax law. Whether you pay your attorney hourly or on a contingent fee basis, legal fees will impact your net recovery and your taxes. If you are the plaintiff and use a contingent fee lawyer, you usually will be treated (for tax purposes) as receiving 100 percent of the money recovered by you and your attorney. This is so even if the defendant pays your lawyer the contingent fee directly.
If your case is fully nontaxable (say an auto accident in which you are physically injured and you receive only compensatory damages), that should cause no tax problems. But if your recovery is taxable in whole or in part, the type of deduction you can claim for the legal fees can vary materially.
Say you settle a suit for intentional infliction of emotional distress against your neighbor for $100,000, and your lawyer keeps 40 percent or $40,000. You might think that you would have $60,000 of income. Instead, you will have $100,000 of income. Up until the end of 2017, you could claim a $40,000 miscellaneous itemized deduction for legal fees.13
That meant you faced several limitations (including alternative minimum tax (AMT)), but at least the fees were deductible. In 2018 and thereafter, there is no deduction for these legal fees. Yes, that means you collect 60 percent but are taxed on 100 percent. Notably, not all lawyers' fees face this draconian tax treatment.
If the lawsuit concerns the plaintiffs' trade or business, the legal fees are a business expense. Those legal fees can be deducted above the line, the best kind of deduction.14 If your case involves claims against your employer, or involves certain whistleblower claims, there is also an "above-the-line" deduction for legal fees.15
That means you can deduct those legal fees before you reach the adjusted gross income (AGI) line on the first page of your Form 1040. But outside of employment and certain whistleblower claims or your trade or business, be careful. There are sometimes ways of circumventing these attorney fee tax rules, but you'll need sophisticated tax help before your case settles to do it.
Caution. Some advisers are worried that the above-the-line deduction is in jeopardy too. Section 62 allows an above-the-line deduction for a "deduction allowable under this chapter." Technically, it promotes an existing below-the-line deduction, to make it a (better) above-the-line deduction. Thus, there is at least an argument that this is a problem Congress or the IRS should clarify. But it is mostly a glitch that is being ignored. Congress surely did not mean to impact the above-the-line deduction. Moreover, after the Tax Cuts and Jobs Act, Congress subsequently extended the above-the-line deduction to SEC whistleblower claims, suggesting that the deduction is still in the law.
9. Punitive Damages and Interest Are Always Taxable
Punitive damages and interest are always taxable, even if your injuries are 100 percent physical. Say you are injured in a car crash and get $50,000 in compensatory damages and $5 million in punitive damages. The $50,000 is tax-free, but the $5 million is fully taxable. What's more, you may be unable to deduct your attorney fees (on this point, see item 8 above). Because the case does not arise out of employment or a trade or business, any taxable money can be 100 percent taxable even if 40 percent goes to the lawyer. The lack of tax deduction for legal fees commencing in 2018 is likely to catch many people by surprise in 2019 at tax return time.
The same can occur with interest. You might receive a tax-free settlement or judgment, but pre- or post-judgment interest is always taxable.16 As with punitive damages, taxable interest can produce attorney fee deduction problems. These rules can make it more attractive (from a tax viewpoint) to settle your case rather than have it go to judgment.
10. Sex Harassment and Abuse
Under the new tax bill, confidential sexual harassment or abuse settlements face special tax rules.17 If the settlement is confidential, the defendant cannot deduct the settlement payment or the legal fees.18 As written, this no deduction rule seems to apply to plaintiff legal fees, too.
Most sexual harassment cases arise in the employment context, in which an above-the-line deduction for plaintiff legal fees applies. But this deduction is now called into question. That surely unintended result for plaintiffs may be corrected. The pending "Repeal the Trump Tax Hike on Victims of Sexual Harassment Act of 2018" would do so.
No plaintiff wants to pay tax on 100 percent and receive 40 percent. Some plaintiffs insist on omitting the nondisclosure provision or a tax indemnity if the plaintiff has his or her tax deduction for legal fees denied. Others agree to a set (usually small) amount of the settlement allocated to sexual harassment. But this may be unrealistic where the whole case is about sexual harassment, and there is no guarantee the IRS will agree.
11. Consider the Defense
Plaintiffs are generally much more worried about tax planning than defendants. Defendants paying settlements or judgments always want to deduct them, and usually they can. A notable new exception applies to confidential sexual harassment or abuse settlements, and related legal fees. Outside this context, even punitive damages are tax deductible by businesses. Only certain government fines cannot be deducted. And even then defendants can sometimes find a way if the fine is in some way compensatory.
Nearly every piece of litigation eventually involves tax issues. For many, the tax issues are tougher and more important for cases that are resolved in 2018 and thereafter. Where possible, urge clients to get some tax help early. It is usually much harder to achieve a positive tax result if the first time someone raises tax issues is when they are doing tax returns (with Forms 1099 in hand) at tax time the year after the settlement.