Is Your Award Taxable? A Look at the Taxation of Judgments and Settlements

One of the most common underappreciated aspects of litigation is the taxation of the outcome, whether by judgment or settlement. This is true for both the plaintiff and defendant. With respect to the plaintiff, how will the litigation proceeds be taxed, if at all. As to the defendant, will a deduction be allowed at all or must it be capitalized or a combination thereof.

Origin of the Claim

The tax treatment of a payment from settlement or final determination is dictated by the “origin of the claim” doctrine. This means in lieu of what were the damages awarded or received.

If it is determined that all or part of the amount received is taxable, further analysis must be undertaken to determine if it is ordinary income, recovery of capital or capital gain. Recoveries are generally taxable and treated as ordinary income if the payments relate to lost profits except when they may be categorized as capital gain if the underlying claim is for damages relating to a capital asset. 

Per Internal Revenue Service Rev. Rul. 85-98 the Internal Revenue Service views the initial complaint as most persuasive although other documents between the parties may be considered. When a payment encompasses multiple claims, an allocation may be needed. A settlement or judgment may provide for an allocation. An allocation in a formal judgment generally is binding on the Internal Revenue Service and the parties unless the facts and circumstances allow for challenge to that allocation. The burden of proof is on the taxpayers. 

As you might expect, the Internal Revenue Code and case law take a very broad view of what is gross income. As a result, almost any amount received will be considered income unless there is an exception or exclusion contained with the Internal Revenue Code or case law.

Internal Revenue Code Section 61

• “General definition 

Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:

(1) Compensation for services, including fees, commissions, fringe benefits, and similar items;

(2) Gross income derived from business;

(3) Gains derived from dealings in property;

(4) Interest;

(5) Rents;

(6) Royalties;

(7) Dividends;

(8) Annuities;

(9) Income from life insurance and endowment contracts;

(10) Pensions;

(11) Income from discharge of indebtedness;

(12) Distributive share of partnership gross income;

(13) Income in respect of a decedent; and

(14) Income from an interest in an estate or trust.”

Even though Internal Revenue Code Section 61 includes the proceeds in the definition of gross income, Internal Revenue Code Section 104 specifically exempts certain categories.

Internal Revenue Code Section 104

U.S. Code Section 104: Compensation for injuries or sickness

“(a) In general 

Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include:

• Amounts received under workmen’s compensation acts as compensation for personal injuries or sickness;

• The amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness;

• Amounts received through accident or health insurance (or through an arrangement having the effect of accident or health insurance) for personal injuries or sickness (other than amounts received by an employee, to the extent such amounts (a) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (b) are paid by the employer);

• Amounts received as a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country or in the Coast and Geodetic Survey or the Public Health Service, or as a disability annuity payable under the provisions of section 808 of the Foreign Service Act of 1980; and

• Amounts received by an individual as disability income attributable to injuries incurred as a direct result of a terroristic or military action (as defined in section 692(c)(2).”

In the context of general lawsuits, the most prevalent are accident-related matters wherein Internal Revenue Code Section 104(a)(2) may be operative. Regulations dealing with Sec. 104(a)(2) provides:

“c) Damages received on account of personal physical injuries or physical sickness

(1) In general. Section 104(a)(2) excludes from gross income the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness. Emotional distress is not considered a physical injury or physical sickness. However, damages for emotional distress attributable to a physical injury or physical sickness are excluded from income under section 104(a)(2). Section 104(a)(2) also excludes damages not in excess of the amount paid for medical care (described in section 213(d)(1)(A) or (B)) for emotional distress. For purposes of this paragraph (c), the term damages means an amount received (other than workers’ compensation) through prosecution of a legal suit or action, or through a Settlement Agreement entered into in lieu of prosecution.

(2) Cause of action and remedies. The section 104(a)(2) exclusion may apply to damages recovered for a personal physical injury or physical sickness under a statute, even if that statute does not provide for a broad range of remedies. The injury need not be defined as a tort under state or common law.”

For automobile accident cases and the like distinguishing between physical and non-physical injuries may be evident. However, in the context of employment matters this may not be the case.

In Domeny v. Commissioner (T.C. Memo 2010-9) the issue of taxation arose in the employment setting. The taxpayer was diagnosed with multiple sclerosis which was exacerbated by workplace issues caused by her manager. The court held that for taxpayer to prevail she “must show that her claim against PACE was based on tort or tort type rights and that the damages were received on account of physical injuries or sickness.” It is important to note that in this case the settlement agreement was “ambiguous regarding any specific reason for the payment.” There was no doubt that the claim was based on tort or tort type rights. The focus was on the second of the Schleir test, that the damages be received on account of physical injury or sickness. It stated, “that the second test can only be satisfied if there is a direct causal link between the damages and the personal injuries sustained.” 

“When damages are paid in connection with a Settlement Agreement, we first look to the underlying agreement to determine whether it expressly states that the damages compensate for personal injuries or physical sickness under sec 104 (a)(2).” “In summary, petitioner has shown that her work environment exacerbated her existing physical illness. It was of no consequence that the taxpayer had the MS condition before the flareup caused by her hostile work environment.” Case held for the taxpayer.

In the aforementioned Commissioner v. Schleier, (515 U.S. 323) (1995) the U.S. Supreme Court held that “[r]ecovery under the ADEA is not excludable from gross income. A taxpayer must meet two independent requirements before a recovery may be excluded under Sec. 104 (a)(2). The underlying cause of action giving rise to the recovery must be ‘based on tort or tort type rights and the damages must have been received on account of personal injuries or sickness.’” 

Attorney Fees

‘Banks v. Commissioner’ (543 US 426 (2005)

In Banks, the U.S. Supreme Court held that attorney fees, including those paid directly to the litigant’s attorney per a contingent fee arrangement are includible in gross income of the litigant. “This rule applies whether or not the attorney-client contract or state law confers any special rights or protections on the attorney, so long as these protections do not alter the fundamental principal-agent character of the relationship”. 

Even though contingent attorney fees are includible income there is no guarantee that those very same fees will be deductible. Internal Revenue Code Section 67 which provides for a deduction of “Miscellaneous Itemized Deductions” in excess of 2% of adjusted gross income is suspended for tax years 2018 through 2025.

Moreover, even in the years that they are permitted, in the year of the recovery the adjusted gross income may be much higher causing the 2% to eviscerate the otherwise allowable deduction. In fact, there have been cases where a successful plaintiff owes more in taxes and attorney fees than the amount of net recovery.

Capital Gain

In cases involving an entity, the fact that there is no sale or exchange of a capital asset should not affect the treatment of the settlement payment. There has been conflicting authority, however, and practitioners have taken positions that in a settlement where there is a payment for damages to a capital asset, the payment should be treated as a return of capital or if in excess of basis, as capital gain, even if there is no sale or exchange. The case law does provide situations where settlement proceeds were treated as a return of capital and capital gain.

The general rule when determining how to treat settlement payments is to determine “in lieu of what were the settlement amounts paid.” “In determining the nature of the claim and thus the taxability of the proceeds, the most important factor to consider is the intent of the payor, considering all the facts and circumstances … Determining the payor’s intent is a factual inquiry that requires a consideration of all factors involved in resolving the claim, including the parties’ allegations, evidence, arguments, and the terms of any settlement.” See Private Letter Ruling 200702032.

Thus, amounts received for injury or damage to capital assets are taxable as capital gain, whereas amounts received for lost profits are taxable as ordinary income.” See Inco Electroenergy v. Comm’r, T.C. Memo., 1987-437 (1987) (quoting Sager Glove v. Comm’r, 36 T.C. 1173 (1961)).

Conclusion

The point to the above is that counsel should include in its analysis of a case the taxability of the anticipated and sought after damages as the tax effect could be substantial.

Douglas Eisenberg, chair of Schenck Price’s Tax Planning Practice Group, represents many closely held entities in a wide variety of areas with a focus on the tax aspects of the transaction.