Tax Treatment of Settlements

Christian Samara, CPA (Mar, 2019)

The case is closed and you just received your settlement or litigation award payment. Just when you thought it was all over, Uncle Sam is knocking at your door looking for his share. You cry objection! Unfortunately, your objection may be overruled. While it may not be the first thing on everyone's mind, knowing whether or not your settlement or litigation award payment is taxable is important in avoiding an unpleasant surprise during tax time. The taxability of your payment may not be the only tax related question arising from your payment. Is the settlement subject to withholding for employment taxes? How do I treat the attorney fees I had to pay out of the settlement? Determining the correct treatment of a settlement or litigation payment, can be a process. Luckily, there is guidance that can help ensure your settlement or litigation award payment gets the appropriate treatment.

Determining the tax consequences of your settlement or litigation payment boils down to determining the character of the payment and the nature of the underlying claim that gave rise to it. To do this taxpayers can look to the "origin of the claim" doctrine, which has been used in courts for many years in determining the nature, and thus the deductibility of certain expenses. According to the doctrine payments for lost income or lost wages and damages are generally taxable as ordinary income. For example, if a taxpayer received a settlement related to unlawful discrimination or involuntary termination, the portion of the settlement related to lost wages is taxable. Punitive damages, that is, payments above and beyond actual damages awarded by the court, are also taxable as ordinary income.

This may lead you to wonder if there are any forms of settlement or litigation payments that are not subject to tax. Fortunately, there are. When the origin of the claim concerns a recovery for physical injury or sickness, even if based upon lost wages due to physical injury or sickness, the IRS provides an exclusion from gross income. Unfortunately, the exact definition of physical injury or sickness is not defined by The Internal Revenue Code. According to the IRS, in order to be considering physical injury there must be some form of observable harm to oneself such as, but not limited to bruising, swelling and bleeding. This has caused controversy, as under the IRS definition, amounts received in settlement for emotional distress generally are taxable, as there is no observable physical harm. However, like most areas of tax law, there are exceptions. If the settlement comes as a result of emotional distress that was caused by observable physical injury or sickness, or if the settlement relates to medical expenses incurred to treat emotional stress then it is not included in gross income, but only to the extent there was no previous tax benefit. In other words, if a taxpayer was able to include the medical expenses paid for emotional distress as an itemized deduction, then the settlement to reimburse them would be taxable. It is worth noting that punitive damages, even when related to physical injury or sickness are generally still includable as gross income and taxable.

Another instance in which settlement or litigation payments may be excluded from gross income is when the payment represents a return of a capital asset destroyed or injured, but only to the extent that the payment does not exceed the taxpayers basis in the capital asset. The calculation of basis can be a complicated process, which could merit its own article, but in the simplest instance, this means only the portion of the settlement beyond what you paid for the capital asset is taxable. If you are unsure of your basis in a capital asset, a tax professional may be able to assist you.

In some instances a portion of a settlement or litigation payment will be includable in gross income, while a portion of it may not. Hopefully in this situation the settlement would provide some sort of basis for allocating the portion includable in gross income, and the portion that is excludable. A tax professional may be able to assist in the determination, but unfortunately, it has been historically difficult without guidance from the court as the burden of proof rests on the taxpayer. If any portion of the settlement or litigation payment represents interest, that amount is taxable as interest income.

Now let's discuss whether your settlement or litigation payment will be subject to withholding for employment taxes. The IRS defines wages as all remuneration for employment with specific exceptions. Unfortunately, settlements or litigation payments related to lost wages are not among the specific exceptions. As such, settlements constituting severance pay, back pay and front pay will be treated as wages, upon which the employer must withhold income tax, the Federal Unemployment Tax Act (FUTA), and the employer portion of Federal Insurance Contributions Act (FICA). However, supplemental unemployment benefits (SUB) pay is excluded from wages.

Finally, let's take a look at attorney's fees. As a general rule, if a taxpayer receives a settlement or litigation payment that is includable in income, the attorney's fees are also included in gross income even if paid directly by the defendant. If the settlement is related to a taxpayer's trade or business, the attorney's fees may be deductible as a business expense. In the past, attorney's fees that are not related to a trade or business, but were for the production or collection of taxable income or help determine, collect or obtain a tax refund were deductible as a miscellaneous itemized deduction subject to 2% of Adjusted Gross Income (AGI). These deductions have been eliminated as a result of the Tax Cuts and Jobs Act of 2017. Any attorney's fees related to settlements excludable from income or personal, living or family expenses are nondeductible.

The tax consequences of receiving a settlement or litigation payment are not always the same. It is important to understand how these tax consequences might affect you to avoid a surprise during tax time. If you have any questions or concerns about settlements or litigation payments, please do not hesitate to contact your tax advisor.

 

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.

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