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January 2012 Tip of the Month

A Reminder on the Tax Rules of Lawsuit Awards

Here's who should really read this article:

-       Individuals receiving lawsuit awards (or if you have a friend or loved one who is);

-       Employment lawyers;

-       Personal injury/medical malpractice attorneys;

-       Tax attorneys;

-       Litigators and other members of the Plaintiff and Defense Bar.

Those who are able are strongly recommended to attend a Camden County Bar Association seminar on February 15th where Marty Abo a seasoned litigator, Frank Allen, Esq., and a tax attorney, Steven Poulathas, Esq., both well versed in structuring such awards, to help him travel the complexing path of such taxation and provide insight on how to avoid the many and significant traps for the unwary.

The conclusion at the beginning? Lawyers who bargain or negotiate settlements need to be sensitive to tax issues.

Payments received as compensation for physical injuries are free of federal income tax. Such is the case even if the monies received are from a court-ordered award or an out-of-court settlement. It also matters not if the payment is in a single, lump sum or paid in installments. Some additional points to consider:

·         Compensation for emotional distress arising out of a physical injury is tax-free because the distress is considered part and parcel of the physical injury or illness.

·         Amounts paid for lost wages will also be tax-free, even though the original salary would have been taxable if when received.

·         Amounts received for medical expenses will be tax-free unless the individual claimed a medical expense deduction for such expenses that are later reimbursed from the settlement or award. Even when there is no specific allocation, the award or settlement is deemed to include a reimbursement for such expenses up to the amount of those expenses.

·         Claims for taxable lost wages or lost profits will generally be reported as ordinary income while claims for injury to a capital asset will be taxable as a recovery of basis and capital gain.

·         Front pay or back pay will be characterized as "wages" for purposes of payroll tax withholdings

·         Interest received on the award or settlement will be taxable.

·         Awards to effectively punish the wrongdoer (i.e. punitive damages) are generally taxable even when paid as a result of a physical injury.

·         Payments for non-physical injuries (i.e. discrimination, wrongful termination, emotional distress not caused by physical injury, invasion of privacy, libel, harassment, etc.) will be taxable. Such amounts for emotional distress are not treated as a physical injury or physical sickness, except to the extent those damages attributable to the emotional distress were used to pay for medical care.

·         You cannot deduct attorney fees incurred to collect a tax-free award or settlement for physical injury. That almost makes sense that a deduction should not be permitted if applicable to the collection of tax-free compensation.

·         If part of your award is tax-free (i.e. physical injury) and the balance is taxable (i.e. interest, punitive damages, non-physical injury, etc.) the recipient is required to report the entire gross amount of the taxable portion of the award as taxable income.  No reduction is made for the related legal fees. The proportionate attorney fees applicable to the taxable portion may be deducted as a miscellaneous itemized deduction (i.e. multiplying the total fees by a numerator of the taxable portion over the denominator of the total amount of the award or settlement).

·         Unfortunately, such "miscellaneous itemized deductions" are only deductible in excess of 2% of Adjusted Gross Income (AGI) and they are completely disallowed for AMT (Alternative Minimum Tax) purposes. Thus, the injured person's actual deduction for the attorney fees related to taxable awards may actually yield little or no tax benefit. They will effectively be taxed on monies they never even saw (i.e. went to their lawyer and taxes).

·         There are two noteworthy exceptions to this unfortunate tax trap.  One is that legal fees will be deductable "above the line" as a Schedule C deduction when the lawsuit arises entirely from the taxpayer's business. The second will occur for legal fees incurred in certain types of unlawful discrimination cases (i.e. whistleblower rights, civil rights, labor/employment rights, etc.).  These can also be deducted above the line" and not as a "miscellaneous itemized deduction".

·         Structured settlements for physical injury awards where payments are received over time rather than in a lump sum can escape taxation.  If done properly, a structured settlement may convert "earnings" (i.e. imbedded interest factor) which otherwise might have been taxable to tax-free.

A Recent Example of how Taxes Can Create Even More Emotional Distress

In a recent 2011 Tax Court Decision (McGowen v. Comm’r., T.C. Memo. 2011-186), the taxpayer sued and claimed she was subjected to a hostile and offensive work environment by a co-worker who actually threw a binder at her, even after reporting the incidents to her employer. Julie McGowen began suffering from emotional distress, taking a medical leave of absence and, after four months, was fired.  She sued claiming sexual harassment, failure to prevent sexual harassment, disability discrimination, failure to prevent discrimination and intentional infliction of emotional distress. She eventually settled with her employer who paid her legal fees of $39,750 and paid her $42,625 for lost income and $42,625 for “physical injury caused by emotional distress.”  The past employer withheld taxes from the lost income and issued a W-2 for the lost income and also issued a 1099-MISC for the emotional distress portion. She did not include the emotional distress component in taxable income believing such damages were received on account of personal physical injuries or physical sickness. The Tax Court found that the emotional distress payment was taxable because there was no evidence of physical injury or suffering (i.e. the binder did not physically injure her) other than from emotional distress, and, under the settlement agreement, damages were not awarded on account of physical injury or physical sickness.

A closing thought? Here's what we've seen attorneys often fail to consider as the litigation begins, as the litigation proceeds, as the litigation concludes, which will ultimately be looked at by the taxing authorities:

  • The complaint,
  • The history of negotiations between the parties,
  • The final verdict or
  • The final settlement agreement.