Overview

Legal settlements in the U.S. easily exceed one trillion dollars on an annual basis. The tax consequences of settlements and damages should be reasonably well known and settled. . However, that is not the case. A fair amount of case law exists in the area leaving one to believe that maybe the rules are not clear cut or well understood. Additionally, not much has been written in the area of the taxation of settlements and damages except by San Francisco attorney Rob Wood who has written virtually every important treatise and article on the topic.

According to Tillinghast, trial attorneys collectively earned $70 billion in 2007. In the absence of tort reform, it is hardly unlikely that attorney income has gone down since that time. The economic impact of settlements for plaintiffs and attorney contingency income is too significant to receive so little attention.

This article is the first segment of a series of articles addressing the taxation of settlements and damages along with discussions of planning ideas to reduce and defer taxable income on this income for both plaintiffs and their attorneys.

Background

Prior to 1994, the IRS had considerable difficulty collecting tax revenues related to settlements. Most plaintiffs seemed to categorize all sorts of settlements as non-taxable because they were on account of “personal injury” and not taxed under IRC Sec 104. IRC Sec 104 did not limit damages to physical injury and sickness. This allocation seemed to occur regardless of whether the settlement was for compensatory or punitive damages as well as cases involving employment, fraud and defamation of character. Form 1099 was not being issued to plaintiffs.

The Small Business Protection Act of 1996 added IRC Sec 104(a)(2) to the Internal Revenue Code changing the landscape for the taxation of settlements and damages. The new section made a small but significant change by limiting tax-free treatment as a result of personal “physical” injuries and “physical” sickness.

Summary of Treasury Regulation 1.104-1

Internal Revenue Bulletin 2012-12 added final regulations which had been pending since 1996 and substantial amounts of litigation regarding the “on account of physical injury and physical sickness” test of IRC Sec 104(a)(2). The final regulations adopt the provision under the proposed regulations that delete the requirement that to qualify for exclusion from gross income, damages received from a legal suit, action, or settlement agreement must be based upon “tort or tort type rights

The final regulations apply to damages paid pursuant to a written binding agreement, court decree, or mediation award entered into or issued after September 13, 1995, and received after January 23, 2012.

IRC Sec 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).

Under the treasury regulations, 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 litigation. The injury need not be defined as a tort under state or common law.

Sorting Out the Basic Issues and Tax Consequences of a Settlement

An analysis of the tax treatment focuses on the nature of the damages. All settlement and damage payments should be reported on Form 1099- MISC. All punitive damages are taxable whether received in relation to a physical or non-physical injury. An exception exists in Alabama wrongful death cases where the only payments for wrongful death under Alabama tort law are punitive damages. Interest payable as part of the settlement should also be reported as income.

IRC Sec 104(a)(2) and Treas. Reg. 1.104-1 provide that only payments that are received on account of a physical injury or physical sickness are excluded from income.  The only payments that are excluded for income tax purposes for non-physical injury are out of pocket medical expenses under IRC Sec 213 for medical expenses incurred to treat emotional distress.

An important step in the settlement process is making a determination of the amount allocable for compensatory damages and punitive damages as well as out-of-pocket.

The taxpayer should report taxable amounts on a gross basis rather than net of legal fees. The taxpayer’s allowable legal fees are deducted on Schedule A  of Form 1040 as miscellaneous itemized deductions, unless the origin of the claim litigated is related to a Schedule C (independent contractor), or a capital transaction.  

The legal fees deducted on Schedule A are a tax preference item for purposes of AMT. For purposes of the AMT Credit, the legal fees which created AMT, are not allowed to generate the credit. They are "exclusion" items.

Aside from the AMT, the phase out of miscellaneous itemized deductions also serves to limit the tax cost of settlements. The phase out reduces the benefit of itemized deductions by eliminating most of miscellaneous itemized deductions above a certain threshold. Itemized deductions are reduced  by the lesser of 80% of itemized deductions and 3% of the amount by which a taxpayer's adjusted gross income (AGI) exceeds the applicable amount.

The applicable amount is $300,000 for taxpayers who file jointly, $275,000 for heads of household, $250,000 for individuals, and $150,000 for married individuals filing separately. The applicable amounts are indexed for inflation for years after 2013.

Summary

The amount of litigation and the considerable amount of damages paid in settlements and damages makes it incredibly important to know the “ins and outs” of settlements and damages. When you know “what is taxable”, you also learn “what is not taxable and can plan. Accordingly, planning measures can be taken to reduce the impact of taxable settlements for plaintiffs and well as their attorneys. This article is the first of a series to outline and examine the taxation of settlements and damages.