Generally, payments issued in connection with a claim or lawsuit brought by employees or non-employees are performed by personnel in accounts payable at the request of management or legal counsel. Normally, because of the sensitive or confidential nature of the matter, crucial information on the purpose of the payments isn’t routinely provided to the personnel. However, sufficient information should be shared among the respective departments to determine the proper tax treatment of any payments. This presentation will focus on the treatment of proceeds from a payment awarded in a legal proceeding, such as a lawsuit, arbitration, or mediation to an employee, former employee, or non-employee.
Information Needed To Tax Lawsuit Payments
You should consider the following when determining the correct treatment of payments arising from a legal settlement or judgment: (1) Determine the character of the payment and the nature of the claim; (2) Determine whether the payment constitutes gross income for income tax purposes; (3) Determine whether the payment constitutes wages for Federal Employment Tax Withholding; and (4) Determine the appropriate reporting requirements for the payment and any fees paid to an attorney.
When is a payment from a lawsuit taxable?
Internal Revenue Code, or IRC, Section 61, states that all income from whatever source derived is taxable, unless specifically excluded by another code section. IRC Section 104 is the exclusion from taxable gross income for certain compensation for injuries or sickness with respect to lawsuits, settlements, and awards. IRC Section 104(a)(2) provides for an exclusion of certain payments from income. This section excludes from gross income damages received from lawsuits or settlements on account of personal physical injuries, or physical sickness.
What is a legal award and settlement?
Legal awards and settlements can be divided into two distinct groups. One group includes those arising from a physical injury, and the other arises from a non-physical injury. The claims from each of the two groups will usually fall into three categories: (1) actual damages resulting from the physical or non-physical injury, (2) emotional distress damages arising from the actual physical or non-physical injury, and (3) punitive damages.
What does the IRS Consider a Physical Injury?
The IRS has not published a formal position on what qualifies as a personal physical injury. The administrative position, however, is that observable bodily harm, such as bruising, cuts, swelling, or bleeding, qualifies as a personal physical injury. In 1996, IRC Section 104(a)(2) was amended to narrow the exclusion from gross income to any amount of any damages other than punitive damages received on account of personal physical injuries or physical sickness.
What is a considered a payment in a lawsuit?
The language in Section 104(a) states: Emotional distress shall not be treated as a physical injury or physical sickness. As discussed in the previous slide, to be excludable from income, an emotional distress recovery must be on account of personal physical injuries or physical sickness, unless the amount is for reimbursement of actual medical expenses related to emotional distress and was not previously deducted under Section 213. The amount of excludable damages shall not be in excess of the amount paid for non-deducted medical care attributable to emotional distress. The term “emotional distress” includes physical symptoms such as insomnia, headaches, and stomach disorders which may result from such emotional distress.
Punitive damages are not excludable from gross income
Punitive damages are not excludable from gross income under IRC Section 104(a)(2). With the enactment of the Small Business Job Protection Act, or SBJPA, Public Law 104-188, Section 1605(a), in 1996, Congress made it clear that punitive damages are taxable regardless of the nature of the underlying claim.
Claims for Wrongful Death and Injury
Claims for wrongful death usually encompass compensatory damages for physical and mental injury, as well as punitive damages for reckless, malicious, or reprehensible conduct. As a result, both claims may generate settlement amounts. Any amounts determined to be compensatory for the personal physical injuries are excludable from gross income under IRC Section 104(a)(2), and any amounts determined to be punitive are not.
Tort Lawsuits and the IRS
There are two types of lawsuit claims. Tort is one of these and involves: • a civil wrong not involving breach of contract for which a remedy may be obtained, or • a wrongful act committed by one person against another person or his or her property, or • the breach of a legal duty imposed by law other than by contract, or • an act that may cause or constitute but is not necessarily a personal injury. A tort award may be received from litigation or settlement of a claim for physical injury or illness, mental pain and suffering, interference with economic relations and/or property damage.
Whether damages based on a contractual claim are taxable usually depends on the underlying claim
Whether damages based on a contractual claim are taxable usually depends on the underlying claim. For example, damages recovered under a contract of insurance would be excludable from gross income if received for personal physical injuries or physical fitness. Please note: recoveries for physical injuries or physical fitness under no-fault statutes can qualify under IRC 104(a)(2).
How to tax Compensatory Lawsuit Damages?
Compensatory damages intend to compensate the taxpayer for a loss; for example, payment to compensate the injured party for the injury sustained and nothing more. This loss may be purely economic, for example, arising out of a contract; or personal, for example, sustained by virtue of a physical injury. Punitive damages, as previously discussed, are also a claim type. The facts and circumstances of each lawsuit settlement must be considered to determine the purpose for which the money was received. Then it can be determined whether these amounts are taxable or excludable. Finally, if prior deductions under IRC Section 213 or any other applicable code section were taken – for example, medical deductions, interest expense, attorney fees, et cetera – then pursuant to the Tax Benefit Rule, amounts received for reimbursement of these expenses would be taxable to the extent includable under the inclusionary part of the Tax Benefit Rule.
Example of Lawsuit Taxation
Assume that a taxpayer is in an automobile accident, suffers actual physical injuries, and as a result of that injury suffers: (a) medical expenses, (b) lost wages, and (c) pain, suffering and emotional distress that cannot be measured with precision. If the taxpayer settles a resulting lawsuit for $30,000, the entire amount would be excludable under IRC Section 104(a)(2).
The medical expenses for the injuries arising out of the accident clearly constituted damages received on account of personal injuries. Similarly, the portion of the settlement intended to compensate for pain and suffering constituted damages on account of personal injury. Finally, the recovery for lost wages is also excludable as being on account of personal injuries, as long as the lost wages resulted from the time in which the taxpayer was out of work as a result of the injuries. The critical point this example illustrates is that each element of the settlement is recoverable, not simply because the taxpayer received a tort settlement but rather because each element of the settlement satisfies the requirement set forth in IRC Section 104(a)(2), that the damages were received on account of personal physical injuries or physical fitness.
Employment Related Lawsuits and Taxes
Employment-related lawsuits may arise from wrongful discharge or failure to honor contract obligations. Damages received compensate for economic loss for items such as lost wages, business income, and benefits are not excludable from gross income unless a personal physical injury caused the loss. The taxpayer can exclude under IRC Section 104(a)(2) only the amount of damages for actual, out-of-pocket medical costs paid to treat any emotional distress if those medical costs had not been deducted on his or her tax return. Libel or defamation of character can result in awards resulting from damages to one’s reputation. Because damage to reputation, be it personal or business, is a non-physical injury, only compensation for out-of-pocket costs to treat emotional distress can be excluded if not previously deducted. Punitive damages and any other compensatory damages arising from these cases are taxable. Discrimination suits usually are brought alleging infringements in the areas of age, race, gender, religion, or disability.
Taxation of Employment Law Suits
These types of cases can generate compensatory, contractual, and punitive awards, none of which are excludable under IRC Section 104(a)(2). Revenue Rule 96-65 states that back pay received in satisfaction of a claim for denial of a promotion due to disparate treatment employment tax discrimination under Title VII is not excludable from gross income under Section 104(a)(2) because it is completely independent of personal physical injuries or physical sickness under that section. Therefore, amounts received for emotional distress in satisfaction of such a claim are not excludable from gross income under Section 104(a)(2) except to the extent that they are damages paid for medical care attributable to emotional distress. Revenue Ruling 96-65 also contains information concerning its effect on other rulings and references to treatments of amounts as wages and compensation. Revenue Ruling 96-65 should be consulted for guidance in certain employment discrimination cases.
How to Allocate Claims for Taxes
Claims are generally resolved in one of two ways: a jury or court verdict or in an out-ofcourt settlement. Determining the correct allocation among taxable and non-taxable payments is usually the most difficult part of the conclusion of the adversarial process. Many issues arise concerning allocations or lack of allocations in settlement cases. In general, an allocation in a settlement agreement is binding for tax purposes to the extent that the agreement is reached after adversarial negotiations at arm’s length and in good faith.
If damages have been clearly allocated to an identifiable claim in an adversarial proceeding by a judge or jury, the IRS will usually not challenge their character because of the impartial and objective nature of the determinations. However, where the Court’s decision is simply an eradication of a settlement entered into by the parties in where there was not an impartial and objective determination of the allocation of the award to its components, a reconsideration of the allocation may be warranted by the IRS.