All About Court Settlements
Settlements occur throughout all the steps of the legal process. From the earliest stages of a case to the final results of a judgement, settlements play a vital role in the court process. A settlement is an agreement of a dispute or case with the intention to resolve and end the dispute; usually mutually agreed on by all parties involved with the agreement of a monetary or property exchange. Settlements can apply to civil or criminal cases. In most cases , parties have a huge incentive to settle and avoid arraigning court. Settling a case is typically much quicker and far less expensive than fighting it out in a courtroom.
Common examples of court settlements include:
1 – Corporations paying to settle a dispute over a defective product
2 – A settlement between the prosecution and defense in a criminal case
3 – Settlement of an argument between business partners
4 – A settlement of a worker’s compensation claim
5 – Settlement of a slip and fall claim
6 – Settlement of a divorce or custody case
Because a settlement occurs outside of the courtroom but requires extensive negotiation and put-together by legal counsel; it’s crucial not only that you have experienced legal representation but that your attorney understands the importance and significance behind court settlements.
Determining if a Settlement is Taxable
An award of back wages, compensatory damages for emotional distress, or punitive damages is typically taxable to the recipient of the award. Although there are some exceptions available, civil damages payments are generally regarded as a return on investment of one’s time and effort and as wages or earned income for one’s labor. The general rule is that damages actually received are taxable even if the damages are not intended to redress lost wages or profits.
Nonetheless, the nature of the damages payment is often determinative of taxability. The IRS has indicated that damages for lost wages, even if specifically called "punitive" damages, do not actually serve a punitive purpose. Therefore, those payments are properly regarded as ordinary income (taxable in the year received and to the recipient), and not a gift or a windfall (no income tax imposed). Damages for physical injury or illness are excludable from gross income under certain specific circumstances. Where that circumstance exists—i.e., the damages relate to actual physical injury, and not to emotional or psychological injury—the entire award is excludable from gross income (not subject to income tax). The laws of many states follow the federal law in this regard. If the damages are related to emotional distress or psychological injury, however, the entire amount is included in the recipient’s gross income, unless the damages are for medical expenses, or, in some cases, sickness. Situations in which a physical injury award is partly excluded and partly taxable are often difficult to develop or demonstrate. The IRS has suggested that there be a clearly discernible and reasonable apportionment between excludable amounts (related to physical injury) and includible amounts (related to emotional distress), even if there are no reasonable, bright-line distinctions as between the two types of damages (e.g., pain and suffering, travel expenses for physical injuries, future loss of earnings, medical expenses attributable to physical injury). A case-by-case analysis of all the facts and circumstances must be performed—apportionment cannot be based on arbitrary figures or formulas.
Physical Injury or Physical Sickness Settlement
If you receive a settlement in connection with an award or damages in a court case due to a physical injury or physical sickness, that money is not subject to tax under IRS rules. Those rules apply regardless of whether or not you receive a lump sum settlement or a structured settlement. In essence, the law cares less about how the settlement is paid out, but more about whether that money was received in order to compensate you for a physical injury or sickness.
Therefore, if you have a broken bone and receive a $500,000 settlement, that $500,000 is tax exempt as long as it’s directly related to that broken bone. Even if that affected your ability to earn income, you will not have to worry about paying taxes on the settlement.
However, the IRS does not define "sickness" in any legal terms. Physical sickness can mean anything from a heart attack to cancer to anything else that might compel you to seek medical assistance. However, if a judge awards a settlement or damage award for a mental injury or emotional distress, you may actually be responsible for paying taxes on that award.
Settlements from an accident, in which you end up with a broken bone that affects your ability to make a living, typically qualify as being free from taxation. Such situations are more to do with physical injuries than emotional injuries.
Emotional Distress and Punitive Damages
Settlements or judgments based on physical injury, including those related to employment law, are generally not taxable. There are caveats including the "Physical Injury or Sickness" rule, as described above. However, to the extent a settlement is for emotional distress or punitive damages, it is taxable (unless the Physical Injury rule applies), and also may be subject to specific additional tax rules discussed below.
According to an IRS memorandum, damages received in a settlement or award that do not specifically relate to physical injury are considered taxable income. Whether identified as emotional distress, mental anguish, or pain and suffering, these amounts — while compensatory in the sense of replacing lost income, paying medical bills or other expenses, or reimbursing for damages — are considered non-physical damages and not excludable from gross income to the same extent that physical damages are.
Additionally, punitive damages are taxable income. While not tax-deductible by the payer, punitive damages paid to an employee are generally subject to taxes to the payee.
With the changes brought about by the Internal Revenue Code of 1986, the question of whether punitive damages are subject to tax depends on when the damages were paid. Prior to August 28, 1986, punitive damages received were tax free. But if the damages were paid after August 28, 1986, those punitive damages became taxable income. The rationale is that the change served as an incentive for the payment of larger amounts to the injured party rather than spending more on legal fees.
Punitive damages assessed against the defendant and paid to a plaintiff in a punitive capacity are subject to taxes and reporting, even if the resultant damages are paid after August 28 of the tax year. In other words, punitive damages are taxable in the year in which they arise.
The bottom line is that while the payment of damages resulting from the resolution of a lawsuit may put the receiver in the same economic position as before the damages were incurred, different tax rules apply and this may lead to unexpected or irregular tax treatment.
Lost Wages and Employment Settlements
Lump-Sum Settlements of Lost Wages and Employment Matters
Settlements are taxable to the plaintiff, even in the case of employment settlements. In an employment context, any settlement, or portions of a settlement, that are attributable to back wages are subject to income and employment taxes. For example, a settlement that is allocated to the payment of back wages is taxable as wages under Section 106(a) of the Internal Revenue Code. Accordingly, Federal taxes, state, and local taxes must be withheld and paid on the back claim damages. Similarly, the employer is liable for the share of employment taxes due on the back claim damages. Since the IRS has ruled that back wages are to be reported as wages for federal tax purposes, under California Employment Training Tax laws, back wages are also subject to the tax. The back wages should be reported on IRS Form W-2 by the employer. Compensatory damages for employment claims that are reimbursement of actual expenses, such as reimbursement of medical bills, with interest, are generally excludable from gross income. In this case, no taxes would be taken out and the employer will not be liable for the employer portion of FICA.
Fees, Expenses and Taxes
Section 104(a)(2) of the Internal Revenue Code provides that the gross income of an individual does not include the amount of damages received (other than punitive damages and interest on an award) on account of personal physical injuries or physical sickness. On its face, that provision seems to justify the non-payment of federal income tax on settlement proceeds. However, tax code section 62 denies an individual the deduction of attorney’s fees if the individual’s gross income exceeds a certain level during the year of settlement.
Pursuant to section 62, legal fees to be included in income are not deductible by individuals whose gross income is greater than $318,400 for married persons filing jointly, $285,350 for heads of households, $276,900 for single persons, and $159,950 for married filing separately.
For example, if a case settles for $250,000 and the client is entitled to $175,000 of which $140 , 000 is for legal fees, the net recovery to the client is $85,000. The client would have to include the gross payment of $250,000 on the form 1040 of whatever year the settlement is received, but the regulative provisions of section 62 require the client to also include $140,000 of legal fees in income. However, since he had enough income to not be able to deduct that level of legal fees, the entire $140,000 of legal fees would be taxable to him in the year received, increasing the effect of the legal fees to $140,000 of additional tax dollars paid.
This is a large increase for a personal injury plaintiff. If the gross recovery is within the allowable parameters, only the $40,000 of withheld will be paid and there will not be an additional $140,000 of taxes. Similar rules apply to other contingent attorneys’ fees resulting in similar increases in tax owed if the settlement is in excess of the allowable amount.
Tax on Settlement Income
For the majority of cases, federal tax law requires parties to report settlement amounts on their personal income tax returns. All taxable settlements must be reported as income by the recipient unless otherwise excluded in law. This means both the plaintiff and defendant must account for the settlement when filing their personal returns. Commonly, the entire settlement must be reported as ordinary income, however, certain cases qualify for capital gain treatment.
Some exceptions to income reporting have been established in common-law, but few have been designed by statute or regulation. These distinctions are particularly relevant in personal injury or wrongful death cases, where recovery tends to be extensive. While the reporting requirements are in flux nationally, most require taxable settlements to be disclosed, regardless of whether the case was tried to verdict or awarded based on settlement negotiations. Nationally, only a select few exceptions will apply, so it is imperative to determine whether a settlement grants the plaintiff or defendant a tax advantage, before fully disclosing all settlement amounts on a personal tax return.
Under current federal law, gross income includes compensation for damages received on account of (a) personal physical injuries or a physical sickness; (b) a physical injury or physical sickness resulting in punitive damages; (c) physical injuries or physical sickness arising from emotional distress or evidence of emotional distress; or (d) the loss of consortium of a spouse or an individual who is legally married under applicable state law on the date of the resolution of the claims. 26 U.S.C. § 104(a) (2). All types of recovery triggered by liability for personal physical injuries are severally and collectively taxable. 26 C.F.R. § 1.104-1.
In most cases, compensation for physical injuries will be fully taxable. Exceptions to the general practice of reporting settlement amounts, exist and may apply if cases present unique factual scenarios. Personal injuries which qualify for capital gain treatment include damages for sexual harassment, emotional distress, and discrimination. 26 U.S.C. § 104(2)(a). Recovery which stems from the taking of property which is not income producing may also qualify for capital gain treatment. 26 U.S.C. § 104(2)(b).
Focus on the income exclusions, or whether or not you are exempt from income reporting requirements. Corporate settlements normally qualify as taxable income. If your settlement qualifies for capital gain treatment, be certain to categorically state the relevant evidence of emotional distress on your personal income tax return. Taxpayers who are unsure of what to include in their filings, are encouraged to seek advice from certified tax professionals for further clarification.
How to Reduce Your Tax Liability
If you have a personal injury, employment, race discrimination, or other type of non-business related case that settles for a large sum of money, it is very likely that you are going to be paying some taxes on that settlement. There are a few things you may want to do to see if you can minimize the amount of taxes you have to pay on your settlement. You will want to consult with a tax professional, such as a CPA, to determine the best strategies for minimizing any tax liability on a settlement.
- It is important to have settlements in writing. If the settlement is not in writing, it is very likely that the entire amount will be taxable income.
- It is very important to make sure the settlement clearly delineates the different portions of the settlement and what they apply to. For example, if you receive a settlement for back wages and emotional distress, make sure these amounts are clearly distinguished from each other in the settlement agreement. And, further, the actual warrant instruments should specify which amounts go to which categories.
- One of the best ways of reducing any tax liability from a settlement is to look for ways to decrease your total tax rate. For example, if you receive a settlement in December, you will be utilizing this money when you are making income in a 25% tax bracket. However, you may be able to avoid this higher tax rate by spreading the income out over the following year(s). You could do this by deferring the payment of the settlement money or breaking the payment into multiple checks over the next few years. Even though you may still end up with the same total settlement sum, the income may be spread out in such a way that it falls in a lower tax bracket — 20%, 15% or even 10%. This may result in a reduction in total taxes owed in the long term.
- At the time of settlement, your attorney may receive some or all of your settlement funds in his/her IOLTA account. The attorney will then deduct expenses, an attorney fee, and any other costs. If you want to minimize taxes, it is important to remember that the tax liability will be passed on to you in accordance with the distribution of money — even though it is your attorney that is writing the checks to the agencies for expenses. So, even though your attorney may be writing checks for expenses and costs, that does not mean the attorney is responsible for these payments. The attorney is merely passing the payments along to the appropriate agencies so that your tax consequence may be lower.
- Consider having a professional tax preparer assess your tax liability on a settlement payment after the settlement is finalized. The tax preparer may have some suggestions on how to legally reduce your liability based on the manner in which you receive the money from your settlement.
Conclusion
In conclusion, knowing whether your court settlement is taxable or not, is very important. Many people who have received a court settlement in the past have been surprised that their settlement is now being audited. Even if you have not received a court settlement yet, it is still good to be familiar with what is taxable and what is not, because at some point in time, you may receive a settlement .
Having a clear understanding of what tax obligations you may have allows you to plan accordingly and avoid any issues with the IRS. However, many issues related to tax obligations can get complicated and the consequences of having misrepresentation can be serious. For this reason, if you are concerned with regarding tax obligations you may have, it is best to consult with a tax professional.
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