The Importance of Plaintiffs Not Letting Defendants Dictate Settlement Tax Strategies
When plaintiffs ignore or defer to defendants on settlement language classifying settlement proceeds, plaintiffs lose the opportunity to influence their tax liability.
November 14, 2024 at 12:02 PM
9 minute read
Tax
Receiving proceeds from a lawsuit settlement will likely be the largest financial transaction a plaintiff experiences in their lifetime. Just like any other major financial change, plaintiffs and their counsel must ensure that the terms of the settlement fit their overall tax and financial plans.
Different settlement proceeds receive different treatment under the U.S. Internal Revenue Code (IRC). For instance, proceeds compensating for a physical injury are usually tax-free per IRC Section 104(a)(2). On the other hand, punitive damages imposed upon the defendant are generally subject to income tax.
When plaintiffs ignore or defer to defendants on settlement language classifying settlement proceeds, plaintiffs lose the opportunity to influence their tax liability.
As a general rule, a plaintiff’s tax liability “hinges on the payor’s dominant reason for making the payment.” See Green v. Commissioner, 507 F.3d 857, 868 (5th Cir. 2007). Courts determine the “dominant reason” by first examining the language of the settlement agreement. Thus, it’s critical for the plaintiff to carefully consider the defendant’s rationale behind settlement payments and gain the defendant’s consent to any classifications.
In addition, a defendant insisting on general release language in a settlement can expose the entire settlement value to tax liability. If this happens and the plaintiff fails to clearly establish which parts of the settlement should be tax free, the entire settlement can be taxed.
Even worse, if a defendant’s classification of settlement proceeds differs from how the plaintiff reports them on their taxes, the plaintiff may be subject to greater risk of an audit or challenge by the U.S. Internal Revenue Service (IRS). However, when a defendant does agree to a plaintiff’s allocation language, the agreement can constitute the “credible evidence” needed during an IRS challenge to shift the burden of proof from the taxpayer to the IRS.
By taking the lead on drafting the language of settlement agreements and how different proceeds are classified a plaintiff can dramatically lower their tax liability and avoid these issues.
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The Tax-Saving Opportunities Plaintiffs Miss Out On by Not Taking the Lead on Settlement Tax Strategies
When plaintiffs concede control to defendants regarding classifying settlement proceeds in tax-saving ways, they can lose out on opportunities to reduce their tax liability.
For example, by allocating a reasonable portion of settlement proceeds to future medical expenses, a plaintiff can save significant future taxes. If they don’t allocate those proceeds as such, they may be unable to deduct medical expenses related to their case until they spend their entire recovery on medical expenses. In catastrophic injury cases, this failure to allocate could increase a plaintiff’s tax liability by millions of dollars.
Another example is a plaintiff’s family members receiving settlement proceeds as co-claimants. A family member of a former plaintiff who provides nursing care to them and receives payment for it will have to pay taxes on those payments since they’ll be taxed as compensation for services. But if the family member receives settlement proceeds as a co-claimant, they can avoid substantial taxation.
Likewise, when a former plaintiff dies, their estate pays tax on their remaining settlement cash or structured settlement payments to the extent the value exceeds the estate tax threshold. But if the former plaintiff’s beneficiaries received those funds as co-claimants, they could avoid estate taxation.
Yet another example is a structured settlement, which provides a plaintiff a tax deferral opportunity for taxable and tax-free settlements. Structured settlements’ tax benefits are designed to encourage plaintiffs to fund their financial futures and avoid dissipating a lump sum recovery. A structured settlement for tax-free damages allows a plaintiff to indirectly invest the settlement value entirely tax-free. When a plaintiff’s damages are taxable, a structured settlement can allow them to defer taxation on the settlement and indirect investments.
However, in each of these examples, plaintiffs and their counsel must guide defendants and their counsel regarding the language used in a settlement agreement.
To allocate settlement proceeds to future medical expenses, defendants and their counsel must agree to settlement language identifying a particular portion of settlement proceeds as compensation for medical expenses. In the second example above, a defendant must be willing to treat and pay the family member as a co-claimant. For structured settlements, defendants must consent to the settlement being structured and agree to additional language in the settlement agreement (as well as an additional document) stating that a structured settlement provider will assume all obligations of a defendant to make future payments.
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Why Defendants Object to Plaintiffs’ Settlement Tax Strategies
In my experience, defendants commonly cite three reasons for resisting tax-focused language requested by plaintiffs and their counsel.
First, defendants sometimes worry that they will be liable for providing tax advice to plaintiffs. A plaintiff can allay this concern by including in the settlement agreement an explicit statement that the plaintiff has not and will not receive or rely on tax advice from the defendant. From the plaintiff’s perspective, there’s little risk using powerful language to disclaim receiving or relying on tax advice.
Second, defendants often worry about their own exposure to IRS penalties for misreporting tax information. Defendants must report taxable portions of settlement payments on IRS Form 1099-MISC or risk a $250 penalty. If their failure to report was “knowing or willful,” the penalty increases to 10% of the reportable amount.
That said, it’s rare for the IRS to assess a penalty against a defendant in a nonwage case. Additionally, defendants are relieved of the obligation to issue a 1099-MISC when they don’t have enough information to determine the taxable portion. This is frequently the case because defendants often cannot identify the taxable portions of the reimbursements they pay to plaintiffs for medical expenses. To know this information would require a defendant to know which expenses the plaintiff previously deducted. Often, plaintiffs counsel or their outside tax advisers can allay a defendant’s concern about potential penalties by walking through the technical basis for the defendant’s compliance.
Third, defendants often worry about being held liable for underwithholding. If they do underwithhold, they’d expose themselves to potential liability. A defendant will owe both their own and the plaintiff’s share of employment taxes if the IRS proves the defendant failed to withhold taxes based on the amount of wages at settlement. The IRS could impose additional penalties and interest, especially if it finds there was negligence or fraud.
If handled correctly, there’s considerable safety for defendants when it comes to the risk of underwithholding. Of course, defendants should carefully consider which portion of a settlement payment to treat as wages. But there is plenty of case law regarding the proper allocation of wages and non-wages at settlement. Thus, defendants can often reduce employment tax through the allocation of wages without risking legal exposure.
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Alleviating Defendants’ Concerns About Settlement Language
Based on the concerns I just mentioned, defendants often insist on including or rejecting language in a settlement agreement concerning a plaintiff’s desired tax position. Plaintiffs can counter defendants’ insistence on adding or removing certain language by inquiring about their concerns, understanding why they have them, and walking them through why particular language is appropriate and doesn’t put them at risk for liability.
For one, defendants often insist upon “general release” language in settlement agreements. That’s a problem for plaintiffs because the tax treatment of each dollar hinges on a defendant’s reason for paying that dollar. A failure to allocate proceeds amongst claims and damages can make an otherwise partially tax-free settlement taxable. Plaintiffs can allay a defendant’s concern in these situations by proposing defense-friendly allocation language that classifies proceeds as compensating for particular “alleged” harms and removing references to taxation.
Likewise, defendants may insist on disavowing clauses in a settlement agreement that state why the settlement proceeds are being paid. These disavowals undermine the purpose of including allocations and other tax-advantaged settlement language because tax treatment of settlement proceeds relies on the defendant’s reason for paying the settlement amount. In these situations, plaintiffs’ counsel should clarify that while a defendant need not make tax representations in a settlement agreement, they need to state their intentions behind making a particular payment. This intention language can come from language excerpted from court papers or letters or emails.
Finally, defendants like to include “tax indemnification” language in settlements. Unfortunately, the IRS and courts have used this language to show a defendant didn’t believe the information included in a settlement regarding allocating payments in a tax-advantaged manner. When plaintiffs’ counsel face this situation, they should clarify how this kind of language increases their clients’ legal exposure. They should also offer to include the defendants’ preferred language in exchange for a larger payout (to make up for the difference in risk-adjusted proceeds because of the unfavorable language), and inquire about what liability the defense is concerned about so plaintiffs’ counsel can respond accordingly.
Separate from this, plaintiffs counsel can suggest the use of a Qualified Settlement Fund (a QSF). Paying to a QSF can allow the defendant an immediate release and tax deduction while preserving the plaintiff’s ability to structure and effect other settlement planning. Rachel McCrocklin, who serves on the expert settlement trust team at Eastern Point Trust Company, regularly finds that QSFs bypass defense objections to tax strategies: “When defendants object to tax language or arrangements the QSF is typically the best path for all parties. Both sides get what they need without having to agree or negotiate—defendants pay and walk away, while plaintiffs complete their ‘settlement planning’ and start to implement it.”
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Plaintiffs and Their Counsel Shouldn’t Settle for 'This Is How We’ve Always Done It'
Plaintiffs have much to lose if their counsel doesn’t take the lead in structuring settlement agreements in ways that provide them tax-saving treatment of settlement proceeds. This treatment often significantly increases what a plaintiff keeps after taxes without costing the defense a dime.
Unfortunately, because defendants and casualty carriers rarely understand this, and often stick to a conservative “This is how we’ve always done it” position, they usually stand between plaintiffs and tax savings. In my experience, these disputes are almost always resolvable.
My best advice for plaintiffs counsel: If you haven’t already retained a settlement planner or financial or tax adviser who can speak to these issues and persuade defense counsel, resolve that problem first.
Jeremy Babener is tax counsel at Structured Legal. He specializes in settlement solutions and serves on the legal committees of the three national settlement planning associations. He previously served in the U.S. Treasury’s Office of Tax Policy. He can be reached at [email protected].
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