MCLE Self-Study: Congratulations on Reaching the Settlement; Don’t Forget About the Tax Consequences
By Stephen J. Turanchik
Mr. Turanchik is an attorney at Paul Hastings LLP. His practice focuses on federal and state tax litigation and controversy matters.
Parties to an employment lawsuit will oftentimes spend hours, if not days, in settlement discussions. Quite frequently, it is only after an agreeable (or perhaps unagreeable) settlement has been reached that the counsel for the parties ask, "What about taxes?"
Origin of the Claim Doctrine
The appropriate tax treatment for a settlement depends upon the claims at issue in the dispute. Stated differently, what was the recovery paid in lieu of? Courts have referenced this approach as the origin of the claim doctrine.1 The basis for the claim will determine the appropriate tax treatment of the settlement payment.
To evaluate the nature of the claims brought by a plaintiff,2 the IRS will look to the allegations in the complaint or statements made in written demands. As discussed below, the IRS and courts will also look to the language of the settlement agreement to assess the claims that were settled between the parties.
Types of Claims in the Employment Context
It is well settled tax law that gross income generally includes all income from whatever source derived.3 The definition of gross income is broad in scope, while statutory exclusions from income are narrowly construed.4
In labor and employment lawsuits, the overwhelming majority of the payments on claims will be taxable. The result is that the majority of tax issues faced at the settlement stage involve allocating between wage claims and non-wage claims. The consequence is that the employer is required to withhold income and employment taxes from wage payments, but non-wage payments are not subject to withholding. For the claimant, allocating amounts to a wage claim means a smaller "take-home" amount. Typical wage income includes back pay (other than lost pay for personal physical injury) and front pay.5 Typical non-wage income includes payments for emotional distress (from discrimination, injury to reputation, etc.), costs, punitive damages, and interest (taxable as interest).
As discussed more fully below, payment of the claimant’s attorney’s fees by the employer will result in income to the claimant even if paid directly to the attorney.
Personal Physical Injuries and Personal Physical Sickness
In 1996, Congress amended Internal Revenue Code (IRC) section 104(a) to exclude only personal physical injury and personal physical sickness from gross income. Prior to the law change, all personal injuries (both physical and emotional) could be excluded from gross income.
The legislative history of section 104(a) makes critically clear that neither emotional distress nor physical symptoms of emotional distress are physical injuries. "It is intended that the term emotional distress includes symptoms (e.g., insomnia, headaches, stomach disorders) which may result from such emotional distress."6
Although rare, claims for personal physical sickness and personal physical injuries can arise in employment-related matters. Amounts received for those claims are excludable from the claimant’s gross income if (1) the claim was based upon tort or tort-type rights, and (2) the damages were received on account of personal physical injuries.
The IRS takes the position that observable or documented bodily harm – such as bruising, cuts, swelling, or bleeding – is evidence of personal physical injury,7 although the IRS has softened this position at times.8
When a claim is based upon personal physical injury or personal physical sickness, and the physical injury or physical sickness causes the taxpayer to suffer emotional distress, then the payment is excluded from damages allocated to such emotional distress.9 Thus, in determining the taxability of emotional distress, one can view the source of the injury as determining the taxability of the payment. If the physical injury was a manifestation of emotional distress, the recovery is taxable. If the emotional distress arises from a personal physical injury, then the recovery is non-taxable.
Cases have primarily focused on personal physical injury and not personal physical sickness. However, two relatively recent cases tackled the issue of whether the taxpayer received payment for physical sickness.
In Domeny v. Commissioner,10 the taxpayer suffered from multiple sclerosis, which was disclosed to her employer. Stresses from work caused her to deal with additional symptoms including vertigo, shooting pains in both legs, difficulty walking because of numbness in her feet, burning behind her eyes, and extreme fatigue. After she received directions from her physician to stay home, the employer terminated her. The suit against the employer sought damages for disability and age discrimination, civil rights infractions, Family and Medical Leave Act violations, and infliction of emotional distress.
The settlement agreement in Domeny was not explicit as to the allocation of damages. Rather, the Tax Court inferred that a portion of the settlement payment should be applicable to the plaintiff’s exacerbated physical sickness based upon the plaintiff’s claims.
In Parkinson v. Commissioner,11 the taxpayer suffered a heart attack as a result of long hours worked under stressful conditions as the chief supervisor of a medical center’s ultrasound and vascular lab. He filed suit in state court for intentional infliction of emotional distress and invasion of privacy.12 The settlement agreement provided for $350,000 "as noneconomic damages and not as wages or other income." This agreement was not a paragon of clarity, as non-economic damages could easily be construed as emotional distress. The Tax Court ruled as follows:
It would seem self-evident that a heart attack and its physical aftereffects constitute physical injury or sickness rather than mere subjective sensations or symptoms of emotional distress. Indeed, at trial [IRS] counsel conceded that the [taxpayer] did "suffer some physical injury," stating that he "suffered several heart attacks."
In the end, because the complaint also alleged psychological injuries, the Tax Court found that one-half of the payment at issue was attributable to physical injuries and one-half attributable to emotional distress.
Importance of Settlement Agreements
Careful drafting of settlement agreements cannot be emphasized strongly enough. As seen in both Domeny and Parkinson, litigation was required to resolve the appropriate tax treatment of the settlement. When there is an express allocation contained in the agreement between the parties, it will generally be followed if the agreement is entered into by the parties in an adversarial context at arm’s length and in good faith.13However, an express allocation can be disregarded when the facts and circumstances surrounding the underlying case indicate that the payment was intended to be for a different purpose.
It is common for the settlement payment to be made on account of multiple claims, in which case an allocation to each claim should be made. The critical issue in evaluating the authenticity of a settlement allocation is the employer’s intent when it paid the settlement.14 The allocation should be based on all facts and circumstances and the terms of the settlement agreement must be consistent with the true substance of the underlying claims.
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It should be noted that neither the IRS nor the courts are bound by the parties’ allocation.15 There must be a reasonable basis for the allocation to pass muster with the IRS.16 For example, IRS Counsel in FSA 200116005 (Dec. 13, 2000) ruled that when the crux of a lawsuit was a contractual claim and the complaint did not mention personal injuries, allocation of a payment to personal injury was inappropriate.
Reporting Payments Made to Attorneys
Generally, the reimbursement of the claimant’s attorney’s fees is taxable to the claimant. If a claimant receives a payment that is includable in income, any amounts allocated as part of a settlement or judgment to attorney’s fees are also includable in the claimant’s income, even if the amount is paid directly to the attorney.17
There is some relief for certain claimants. An above-the-line deduction is available for claimants for amounts attributable to attorney’s fees and costs on account of claims of unlawful discrimination, as well as certain claims against the government, including claims brought under the False Claims Act.18
Payment to attorneys must be reported to the IRS. The manner of reporting can seem counter-intuitive because the payor must report the payment on behalf of the claimant as well as the attorney. The result is that the same amount is reported twice to the IRS.
Examples 1 and 3 in the Treasury Regulations set forth the mechanism for reporting these payments. Example 1:
One check – joint payees – taxable to claimant. Employee C, who sues employer P for back wages, is represented by attorney A. P settles the suit for $300,000. The $300,000 represents taxable wages to C under existing legal principles. P writes a settlement check payable jointly to C and A in the amount of $200,000, net of income and FICA tax withholding with respect to C. P delivers the check to A. A retains $100,000 of the payment as compensation for legal services and disburses the remaining $100,000 to C. P must file an information return with respect to A for $200,000 under [IRC section 6045(a)(1)]. P also must file an information return with respect to C under [IRC sections 6041 and 6051], in the amount of $300,000. See [Treas. Reg. sections 1.6041-1(f) and 1.6041-2]. 19
In this example, the employer is reporting $300,000 to the employee and $200,000 to the attorney, even though the amount of the settlement is for $300,000 (not $500,000).
Example 3 of Treasury Regulation section 1.6045-5(f) deals with the prospect of separate checks being issued to the plaintiff and to plaintiff’s counsel. It provides:
Separate checks – taxable to claimant. C, an individual plaintiff in a suit for lost profits against corporation P, is represented by attorney A. P settles the suit for $300,000, all of which will be includible in C’s gross income. A requests P to write two checks, one payable to A in the amount of $100,000 as compensation for legal services and the other payable to C in the amount of $200,000. P writes the checks in accordance with A’s instructions and delivers both checks to A. P must file an information return with respect to A for $100,000 under [IRC section 6045(a) (1)]. Pursuant to [Treas. Reg. §1.6041-1(a) and (f)], P must file an information return with respect to C for the $300,000.
Even though the plaintiff only receives $200,000 directly, the payor corporation must report $300,000 to account for the amount paid to plaintiff’s counsel.
Closing Thoughts
In the transactional world for legal work, tax counsel are frequently consulted. One does not always think about involving tax advisors in the litigation context. However, what is clear from the IRS guidance and the case law in this area is that obtaining the advice of tax counsel will minimize any potential tax headaches should the IRS decide to review the settlement agreement.
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Notes:
1. See United States v. Gilmore, 372 U.S. 39, 49 (1963).
2. Depending upon the stage of the dispute between the employer and employee, the employee will either be a claimant or a plaintiff if suit has been filed. The terms claimant and plaintiff are used interchangeably throughout this article.
3. IRC § 61(a); Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955).
4. Commissioner v. Schleier, 515 U.S. 323, 328 (1995).
5. The Fifth Circuit has found front pay to be non-wage income. See Dotson v. United States, 87 F.3d 682, 689 (5th Cir. 1996) (holding only back pay was wages). While Dotson is still good law in Texas, Louisiana, and Mississippi, the IRS continues to assert that front pay is wage income in the rest of the country.
6. See H.R. CONF. REP. No. 104-737, at 301, n. 56, reprinted in 1996 U.S.C.C.A.N. 1677, 1792-93.
7. See IRS Off. of Chief Couns. Mem. UILC: 61.00-00, 3101.00-00, 3111.00-00, 3402.00-00, Income and Employment Tax Consequences and Proper Reporting of Employment-Related Judgments and Settlements (Oct. 22, 2008).
8. See IRS Off. of Chief Couns. Advice Mem. 200809001 (recovery relating to sexual molestation was considered to be from personal physical injury, even though taxpayer could not demonstrate observable bodily injury, as the harm had occurred years before).
9. IRC § 104(a)(2). The House Report for IRC § 104 explained that "[b]ecause all damages received on account of physical injury or physical sickness are excludable from gross income, the exclusion from gross income applies to any damages received based on a claim of emotional distress that is attributable to a physical injury or physical sickness." See H.R. CONF. REP. NO. 104-737, at 300-01, reprinted in 1996 U.S.C.C.A.N. 1677, 1792-93.
10. T.C.M. 2010-9 (2010).
11. T.C.M. 2010-142 (2010).
12. The taxpayer also filed suit in federal court. However, that case was dismissed.
13. See Bagley v. Commissioner, 105 T.C. 396, 406 (1995), aff’d 121 F.3d 393 (8th Cir. 1997).
14. See Agar v. Commissioner, 290 F.2d 283, 284 (2d Cir. 1961).
15. See Robinson v. Commissioner, 70 F.3d 34 (5th Cir. 1994).
16. See Phoenix Coal Co., Inc. v. Commissioner, 231 F.2d 420 (2d Cir. 1956).
17. See Commissioner v. Banks, 543 U.S. 426 (2005) (holding that when a litigant’s recovery constitutes income, the litigant’s income includes any portion paid to the attorney as a contingent fee under the anticipatory assignment of income doctrine). If the attorney’s fees relate to a non-taxable recovery, i.e., personal physical injury, then the recovery of attorney’s fees is non-taxable to the claimant.
18. IRC § 62(a)(20). The Internal Revenue Code identifies the types of qualifying "unlawful discrimination" by reference to a long laundry list of laws that provide for employment claims. See IRC § 62(e)(1) – (18).
19. Treas. Reg. § 1.6045-5(f).