Tax Newsletter

What Settlement Proceeds Are Taxable?

December 2013

Dear Reader:

Few things are as complex yet as imprecise as the United States tax code. For example, we are expected to pay taxes on certain types of income, yet it is up to each of us to discern what the IRS considers income. In fact, according to the National Taxpayers Union, there is a 31.5 billion dollar industry dedicated to helping Americans makethese determinations and file their returns each year.

One area in which the distinction of income is particularly ambiguous is that of settlement proceeds. This includes scenarios such as lawsuits and legal judgments, private out-of-court agreements, and insurance settlements.

Like most things, whether or not you must claim settlement proceeds as income depends on the various facts and circumstances surrounding each particular case. However, if you do owe taxes and fail to pay them, you could get fined with hundreds or even thousands of dollars in penalties, depending on the size of the settlement. And the IRS will prosecute cases in which qualifying settlement income is under-reported.

The simple reality is that we live in a litigious society. That may be unfortunate or fortunate, depending on which side of the judgment you sit. However, some settlements are taxable, some are not, and some comprise a combination of taxable, deductible, and tax-free income. We often hear about large settlements and may be under the impression that the recipient is set for life; however, between legal fees and taxes, that may not be the case

As just one example, many "first responders" on the scene during the horrific September 11, 2001 attacks in New York received their final settlements about 10 years later. One NYPD detective was initially quoted a city settlement payout of between $532,826 and $650,267. However, his event-related asthma and other ailments were subsequently downgraded in terms of severity and thus settlement payout. In the end, after the deduction of law-firm expenses ($9,757.48) and attorney fees ($26,430.44), he only received a net total of $79,292.33. This month we discuss the various types of settlements and the subtle nuances that
determine whether and how they are considered taxable. We hope you find the information useful.


Jennifer Lincicum

 Tax Liability Nuances of Lawsuit Settlements

It's important to understand the subtle nuances of cash settlements because they can be negotiated from the outset in a manner designed to minimize taxes. An important element to the drafting of a settlement agreement is the allocation of specific amounts of the settlement to specific causes or expenses. This is because some allocations are taxable while others are not.

Let's start this discussion with an overview of the various types of settlements and, as a general rule, their taxable status.

Physical Injury or Illness
One of the least ambiguous settlement determinations, for tax purposes, is that issued for personal injury or illness. However, while the settlement itself may not be subject to income taxes, the situation may be complicated because these negotiations may drag on for months or even years, during which time you may claim medical expenses as an itemized deduction on your tax return(s).

If no such deduction was ever claimed, then the full amount of the settlement that is allocated to
medical expenses related to the injury or sickness is not considered taxable income. However, if you receive a settlement for a physical injury or illness and you did claim related medical expenses as tax deductions on one or more previous tax returns, you must include in your income the amounts previously deducted to the extent that these deductions provided a tax benefit.

Emotional Distress
What's interesting about the emotional distress allocation of a settlement is that you actually have to make a determination as to whether your mental anguish was a direct result of physical injuries, or your garden variety worry and stress. Awards compensating for emotional distress related to a physical injury or
sickness are not taxable. However, proceeds received for emotional distress or mental anguish not deemed related to a specific personal physical injury or illness must be included as taxable income. While this may not be an easy determination, it gets even more complicated. The amount you allocate as taxable can be reduced by:

  • Any amount you may have paid out for medical expenses attributed to emotional distress or mental anguish not previously deducted, and
  • Previously deducted medical expenses for such distress and anguish that did not provide a tax benefit.

Unfortunately, the U.S. tax code does not account for the mental distress conceivably resulting from trying to accurately make these determinations.

Lost Wages/Profits
Employment-related settlements, such as those awarded for unlawful discrimination or termination, are generally considered the return of lost wages such as severance pay, back pay, and even front pay. Since we are responsible for paying taxes on earned income as a general rule, this type of settlement is also subject to income taxes. The settlement also may be subject to your Social Security wage base, thus Social Security and Medicare taxes may be taken out as well in the year proceeds are paid.

As for business owners, a settlement received for lost profits may likewise be subject to self-
employment taxes.

Property Loss of Value
If you are awarded a settlement for the loss of, and therefore in theory at least, for the replacement of personal property, it is generally not considered taxable. For example, let's say someone accidentally drives his car through the window of your home or business. The allocation of an insurance or lawsuit settlement to the loss of property does not have to be included in your taxable income. Nor for that matter, as discussed previously, would any allotment attributed to medical expenses related to physical injuries suffered.

Be aware, however, that while a property settlement for loss of value that is less than the adjusted basis
of the property is not taxable, you do have to reduce your basis in the property by the amount of the settlement. Should the settlement exceed your adjusted basis in the property, the excess cash award would be considered income and consequently taxable.

Punitive Damages
As a general rule, although hardly universal, damage awards are generally taxable as income. This may be true even if they are related to physical injury or illness, since a damages allotment is generally above and beyond medical expenses. For business owners, damage awards may be related to a patent or
copyright infringement, breach of contract, or interference with business operations. Since these scenarios are related to the loss of potential revenues, the subsequent damages award is subject to taxes.

Attorney Fees
You have to presume that attorneys pay taxes on the fees they receive, so it stands to reason that any contingency amount or flat fee you pay an attorney for helping you negotiate a settlement would not be subject to your own income taxes. You would, in many cases, be wrong.

Legal fees are not deductible for awards that are not taxed. Legal fees arising from a settlement that is partially taxable will be allocated based on the ratio between the taxable amount and the total amount received. For example, say your attorney worked on a 40 percent contingency fee pending the outcome of your settlement. Unless your award is 100 percent allocated to a physical injury or illness, employment dispute, or involves your trade or business, you are attributed as receiving the full amount and may not deduct the 40 percent you pay your attorney.

In the case of an unlawful discrimination suit, you may be able to deduct attorney fees and court costs paid to recover a judgment or settlement for a claim against the United States government, or under section 1862(b)(3)(A) of the Social Security Act. However, the amount you deduct cannot be more than the amount of the settlement you include as income for the tax year.

Structured Settlements
A judgment award issued as a structured settlement annuity may, in fact, pay out a portion of tax-free income over the payout period. This is because personal annuity payouts are subject to an exclusion ratio of IRC Section 72, which is derived by dividing the settlement amount (referred to as the premium paid for the annuity) by the total expected payout. This exclusion ratio is then multiplied by the annual annuity payment, and this results in a portion of the income payout being excluded from taxes. You will receive a Form 1099 from the life insurance company indicating the payout amount you must report as taxable income each year. As a general rule of thumb, a structured settlement can save you somewhere between 25 percent and 35 percent in state and federal taxes on interest income that would otherwise be subject to tax. The exact amount depends on your tax-bracket.

Be aware that this exclusion ratio will not apply to an annuity policy you purchase on your own with the proceeds from a settlement. It applies only to a structured settlement issued as the actual award. The distinction lies in that the recipient may not have any "control" over the annuity contract in order to receive tax-free payments.

Because of the similarity to a structured settlement, it is often mistaken that receiving a lawsuit settlement in the form of monthly payments or an annuity will avoid income taxes. While that's not the case, an
annuity can offer somewhat of a tax advantage. In other words, since the full settlement amount is doled out in annual payouts, the amount of taxes due on the income received each year would be incremental, and thus have lower taxes in any given year than if the proceeds had been paid out in one lump sum.
For example, take the case of a one million dollar settlement distributed as an annuity over a 10-year timeframe. That would mean $100,000 in income is paid out per year, which would be taxed at a lower income tax rate (28 percent for single filers) than a one million dollar lump sum (39.6 percent).

Seek Professional Help for Settlements
Obviously, the tax law on lawsuit and insurance settlements is not only complex, it can be subjective. It's a good idea to work with a seasoned tax advisor who has experience with this type of transaction.

Recent Cases and Rulings

Gutierrez v. Commissioner of Internal Revenue. Docket No. 21671-08, U.S. Tax Court. November 7, 2011
Antonia Gutierrez, who did not speak English, was a vineyard worker subjected to gender discrimination, harassment, wage violations, lack of meal and break periods, exposure to pesticides, and more. Her settlement agreement for $35,000 stated that the award was for emotional distress, damages, and attorney fees. Despite the evidence that Gutierrez suffered respiratory damage, constant headaches, loss of vision and more, the IRS filed a petition claiming that the entire proceeds were taxable due to the wording of the settlement agreement. The Tax Court agreed with the IRS.

Commissioner of Internal Revenue v. Banks. No. 03-892, 543 U.S. 426, Supreme Court of the United States. January 24, 2005
In 1986, John W. Banks was fired from his job as an educational consultant with the California Department of Education. He filed a civil suit alleging employment discrimination on the basis of race, color, religion, national origin, or gender discrimination. After a trial commenced in 1990, the parties settled for $464,000. Banks paid $150,000 of this amount to his attorney pursuant to the fee agreement, and did not include any of the $464,000 as gross income in his 1990 federal income tax return. The court ruled that the full settlement amount constituted income, including the portion paid to the attorney, and was therefore taxable.

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