When considering settlements, it is also important to consider one of life’s certainties: taxes. A potentially taxable event may occur whenever money changes hands—even in the context of a settlement. See Internal Revenue Code (“IRC”) § 61. Parties should understand the tax consequences of settling a litigated matter before signing the settlement agreement and making or receiving payments. The relevant considerations may include whether any required payment will be treated as income to the payee, be treated as a capital versus ordinary gain or loss, be taxable and at what rate, affect the basis of a particular asset, create a reporting obligation, be a deductible business expense, or require withholding. The settlement could also be treated and taxed differently, both for the payor and for the payee, depending on the type of claim, the causes of action involved, and the way payments are allocated in a settlement agreement.
By answering these questions first, it may be possible to plan for the tax consequences of a settlement payment by allocating or characterizing the payments in a particular way. For example, if an employee sues an employer for discrimination and the parties decide to settle, the employer can likely deduct, as a business expense, money designated as wages, but could not deduct money designated as payment for humiliation. Or suppose an employer settles a claim involving everance pay under an employment contract. If a settlement payment is designated as underpayment of wages, underpayment of employment taxes is implicated and withholding of taxes from the payment may be required. See IRC Subtitle C.
It is not just employment lawyers who should review a settlement’s tax consequences. Settlement of claims involving a contract for services performed by an independent contractor could trigger an obligation to file a Form 1099. IRC § 6041. Claims involving Canadian companies could implicate requirements under the Internal Revenue Code and/or international treaties, including reporting or withholding requirements. See IRC Subtitle N. Payments made as part of structured settlements (often used to settle personal injury actions) can carry their own tax consequences. While allocation of payments between causes of action cannot always eliminate an undesired tax consequence, knowing about the tax implications of a settlement before incurring the obligation can help parties make informed decisions about whether to settle, and what to propose in a settlement agreement.