In 2015, the International Agency for Research on Cancer (IARC) classified glyphosate, the active ingredient Roundup, Monsanto’s herbicide/weed killer, as “probably carcinogenic to humans.” Since that release, at least three California juries have found Monsanto, now owned by Bayer, liable for causing non-Hodgkin lymphoma in consumers who have used the weed killer in their employment or for personal use.

In the first groundbreaking case, the jurors found Monsanto liable for $289 million by causing a terminal and rare form of non-Hodgkin lymphoma in a former school groundskeeper. The judge ultimately ordered Monsanto to pay a reduced but whopping $78,500,000 (i.e., $39,500,000 for compensatory damages, $39,000,000 for punitive damages). Although the first case is under appeal, another jury trial found Monsanto liable to pay $80 million, and yet another came out with $2.055 billion to the plaintiffs ($55 million in compensatory damages and $2 billion in punitive damages). I understand yet another case was ordered to go to mediation, attempting to forge a settlement, but that over 13,000 suits have been started against Monsanto alleging Roundup causes cancer.

My cause for concern? How about that all these huge settlements, which we’re sure many might think would be tax free, can net the plaintiffs but 3% or even 1.3% of the award in their pocket!

But first, the technical backdrop.

For years, confusion and litigation abounded about the taxability of damages for nonphysical injuries such as gender and age discrimination or in harassment cases. Internal Revenue Code (IRC) section 61 states that all income from whatever source derived is taxable income, unless specifically excluded by another code section. The only provision that specifically addresses income exclusions for any lawsuit proceeds is IRC section 104(a)(2), which excludes from income amounts paid by suit or agreement for personal injuries or sickness. When the Small Business Job Protection Act was signed into law in 1996, years of litigation ended by stating that punitive damages—whether or not related to physical injury—are not excludable from gross income. Awards for nonphysical injuries are not excludable except for amounts paid for medical care attributable to emotional distress.

The legislative history of the 1996 Act, as it related to IRC section 104(a)(2), provided useful insight into what was or was not excluded from taxable income because of “physical injuries or physical sickness.” Generally, if the primary injury is physical, then all resultant damages (except for punitive damages or interest) are excludable. This is the case even if the damages are measured by lost wages. However, if the primary injury is not physical, then the resultant damages are not excludable even if the action caused emotional distress, which might cause headaches, ulcers, teeth grinding, insomnia, etc. Punitive damages will generally be included in gross income and taxed when received because of personal injury or sickness whether or not related to a physical injury or physical sickness. Damage recoveries for other than physical injuries or sickness will be taxed. Emotional pain and suffering or emotional distress is not considered a physical injury or illness excludable from taxation. Other than for the actual medical expenses incurred, damages received for a “wrongful discharge” claim, race and age discrimination, injury to reputation accompanied by a claim of emotional distress, and similar non-physical claims will all be included in gross income.

And what about the legal fees?

What is the tax treatment of legal fees where the award is not excluded as a physical injury?Wouldn’t you think that the most a plaintiff might be taxed by the IRS or their state would be on their actual recovery, net of legal fees and other costs? Typically, the lawyer’s trust account receives the gross award, the attorney takes his or her fee and costs advanced, remitting to their client the net amount. Alas, in the IRS’ view, 100% of the award is gross income to the plaintiff, even if paid directly to the plaintiff’s attorney by the defendant.

In the 2005 Supreme Court decision, Comm’r v. Banks, 543 U.S. 426 (2005), the court determined that the plaintiff is considered to receive the gross award, including any portion that goes to pay legal fees and costs. The IRS rules for Form 1099 reporting bear this out. A defendant or other payor that issues a payment to a plaintiff and a lawyer must issue two Forms 1099. The lawyer and client each should receive a Form 1099 reporting they received 100% of the money. Such plaintiffs (including whistleblowers) must report the gross payment as their income. How about just having the lawyer issue two separate checks (one for the attorney and the balance to the client)? Sorry, but according to the Banks decision and IRS Form 1099 rules, defendants need to issue a Form 1099 to the plaintiff for the full settlement, even if part of the money is paid to the plaintiff’s lawyer.

Good news for some cases: the above-the-line deduction.

Right before the Supreme Court chimed in on its Banks decision, in 2004 Congress added an above-the-line deduction for legal fees, but only for certain types of cases. This above-the-line deduction, reducing taxable income to arrive at “adjusted gross income” (AGI), applies to any claim under: the federal False Claims Act, the National Labor Relations Act, the Fair Labor Standards Act, the Employee Polygraph Protection Act of 1988, and the Worker Adjustment and Retraining Notification Act; and claims under certain provisions of the Civil Rights Act of 1991, the Congressional Accountability Act of 1995, the Age Discrimination in Employment Act of 1967, the Rehabilitation Act of 1973, the Employee Retirement Income Act of 1974, the Education Amendments of 1972, the Family and Medical Leave Act of 1993, the Civil Rights Act of 1964, the Fair Housing Act, the Americans with Disabilities Act of 1990, Chapter 43 of Title 38 of the U.S. Code; and sections 1977, 1979 and 1980 of the Revised Statutes.

Basically, this above-the-line deduction applies to any claim under any provision of federal, state or local law, whether statutory, regulatory or common law, that provides for the enforcement of civil rights or regulates any aspect of the employment relationship. Under 26 U.S. Code §62(a)(21), as amended by the Bipartisan Budget Act of 2018, an SEC or Commodity Futures Trading Commission (CFTC) whistleblower receiving an award from the SEC whistleblower program or CFTC whistleblower program can also claim the legal fee as an above-the-line deduction.

The Appellate Courts have generally been split on whether contingent attorney fees paid by a taxpayer are excludable from gross income. As we alluded to earlier, the IRS typically requires the amount of an award or settlement to be included in gross income (unless specifically excluded). Prior to 2018, the taxpayer was then generally entitled only to a miscellaneous itemized deduction for the contingent legal fee payment, the value of which was limited (often substantially) because of the 2% threshold on miscellaneous itemized deductions, the phase-out of deductions for high-income taxpayers and the non-deductibility of such fees for the alternative minimum tax (AMT). Contrast this to only including in income that portion of an award net of the contingent fee paid to the taxpayer’s attorney.

This above-the-line deduction means you pay no tax on the attorney fees or, put another way, will be only taxed on the net award you actually receive. Under the Tax Cuts and Jobs Act of 2017 (TCJA), miscellaneous itemized deductions were eliminated (at least until 2026 so stay tuned). If you don’t qualify for the above the line deduction, you are paying taxes on money you paid your attorney and never saw. The TCJA effectively burdened a new tax on many a lawsuit award by removing the deduction of legal fees and costs on all too many settlements, especially when interest and punitive damages come into play. Ouch!

The Bizarre New Tax Math

In the more recent case, Pilliod v. Monsanto, the plaintiffs were awarded by the jury approximately $55 million in compensatory damages and $2 billion in punitive damages. It’s not unusual for legal fees and reimbursed costs to rub as much as 50% of the award. If so, they would get to keep half, or $27.5 million of the $55 million compensatory award. Since it is for their lymphoma, that portion should escape taxation. The $2 billion award for punitive damages would be consumed by about 50% of legal fees and costs, leaving the suffering married couple $1 billion pre-tax. Well, we indicated the $2 billion in punitive damages was taxable with no deduction for the estimated 50% going to the lawyers and case costs, and would be further reduced by 37% federal income tax and approximately 13% in California taxes. For you tax geeks like us, under the TCJA with the significant limitations on SALT (State and Local Tax) deductions, you can just about forget tax-effecting for the deduction of state taxes against federal taxable income. Okay, so after the attorneys are paid, the case costs advanced repaid, the federal taxes paid and the state taxes paid, the plaintiffs would be left with $27.5 million or 1.34%. Not exactly chump change, but move the decimal point around and see how a lesser award might fare. With or without appeals, the after-tax math/recovery, is scary

Had the settlement involved a plaintiff’s business, the legal fees should be a business deduction while the attorney fees and costs would be deductible for certain whistleblower claims. But in other cases, as we’ve commented here, plaintiffs are out of luck unless they are awfully creative. Sometimes, there may be ways to circumvent these tax rules, but you’ll need sophisticated tax help to do it. Advice on the taxation of damage awards before the case settles is best if you hope to avoid a terrible tax result.

Recipients of settlements and judgments generally worry more about the tax issues than payors do. But a defendant preparing to pay a settlement or judgment should also find the tax treatment of the payment to be important. A payment to resolve litigation should involve one or more of: 1) an ordinary and necessary business expense deduction; 2) a deduction as an investment expense; 3) a payment that is not deductible but must be capitalized as part of the cost of an asset; 4) a non-deductible personal expense; or 5) a non-deductible fine or penalty. The Internal Revenue Code does not expressly allow deductions for damages or settlement payments but assuming the requisite business nexus, defendants deduct settlements or judgments, including legal fees, with little issue.

What’s it all mean? We’ve seen plaintiffs holding out for more money to make up for an increased tax liability. Also, some lawyers believe a greater number of claims have been made alleging physical injuries in some harassment or discrimination cases. Attorneys may wish to seek the help of CPAs to help them analyze and quantify claims for damages or settlement offers. By discussing with the accountant or tax attorney the tax or financial impact of filing a claim under several scenarios, consideration can be given to maximizing the after-tax recovery.  CPAs also might consult with defense counsel, preparing reports or counter-reports where necessary, and even advising them on settlements of legitimate claims that might minimize income taxes, which could cause lower payments by the attorney’s clients/payors.

Martin H. Abo, CPA/ABV/CVA/CFF, is a principal of Abo and Company, and its affiliate, Abo Cipolla Financial Forensics, CPAs – Litigation and Forensic Accountants, with offices in Mount Laurel, NJ; Morrisville, PA; and Franklin Lakes, NJ.