Wednesday, October 11, 2017
Many legal cases are settled out-of-court. Cases could involve divorce, wrongful death, securities fraud, false advertising, civil rights, sexual harassment, product liability, reverse discriminations, or damages for a spilled cup of hot coffee just to name a few. But, if a recovery from a lawsuit or out-of-court settlement is obtained, the tax consequences must be considered.
The tax treatment of settlements and court judgments, that’s today’s topic.
Recoveries from out-of-court settlements or as a result of judgments obtained may fall into any one of several categories. Quite clearly, damages received on account of personal physical injury or physical sickness are excluded from income. I.R.C. §104(a)(2). Thus, amounts received on account of sickness or mental distress may be received tax-free if the sickness or distress is directly related to personal injury. For instance, settlement proceeds from a wrongful termination suit that are allocable to mental distress are excludible from income where the mental distress is caused directly by the wrongful termination. See, e.g., Barnes v. Comr., T.C. Memo. 1997-25. Those amounts that are allocated to punitive damages are not excludible. Id.
As the regulations point out, nontaxable damages include “an amount received (other than workmen's compensation) through prosecution of a legal suit or action based on tort or tort-type rights, or through a settlement agreement entered into in lieu of such prosecution.” Treas. Reg. § 1.104-1 (1970). The IRS has determined, for example, that excludible damages include damages for wrongful death (Priv. Ltr. Rul. 9017011 (Jan. 24, 1990)); payments to Vietnam veterans for injuries from Agent Orange (Priv. Ltr. Rul. 9032036 (May 16, 1990)); and damages from gunshot wounds received during a robbery (Priv. Ltr. Rul. 8942083 (Jul. 27, 1989)).
Categorization of a settlement or award is also highly dependent on how the wording of the legal complaint, settlement and release are drafted. Wording matters. This point was evident in a recent Tax Court case. In Stepp v. Comr., T.C. Memo. 2017-191, the petitioners, a married couple, could not exclude payments received in settlement of the wife’s Equal Employment Opportunity Commission complaint in which she alleged disability and gender-based discrimination, and retaliatory harassment for a job reassignment. The Tax Court noted that each of the complaint, settlement and release provided for emotional and financial harms. There wasn’t mention of any physical injury or sickness. Perhaps those documents were drafted without much thought given to the tax consequences of any eventual award or settlement.
1996 Legislation and the Aftermath
1996 legislation specified that recoveries representing punitive damages are taxable as ordinary income regardless of whether they are received on account of personal injury or sickness. Small Business Job Protection Act of 1996, P.L. 104-188, Sec. 1605(a). See, e.g., O'Gilvie v. United States, 519 U.S. 79 (1996); Whitley v. Comr., T.C. Memo. 1999-124. But punitive damages that are awarded in a wrongful death action are not taxable if applicable state law in effect on September 13, 1995, provides (by judicial decision or state statute) that only punitive damages may be awarded. In that case, the award is excludible to the extent it was received on account of personal injury or sickness. Small Business Job Protection Act, P.L. 104-188, § 1605(d)). The enactment also made it clear that damages not attributable to physical injury or physical sickness are includible in gross income.
In 2006, the U.S. Circuit Court of Appeals for the District of Columbia ruled that the distinction drawn in the 1996 amendment was unconstitutional. Murphy v. United States, 460 F.3d 79 (D.C. Cir. 2006). In the case, the plaintiff sued her former employer and was awarded $70,000 ($45,000 for mental pain and anguish and $25,000 for “injury to professional reputation”). The plaintiff originally reported the entire $70,000 as taxable and then filed amended returns excluding the income. The IRS maintained that the entire $70,000 was taxable, and the trial court agreed. On appeal, the court held that the $70,000 was not excludible from income under the statute, but that I.R.C. §104(a)(2) was unconstitutional under the Sixteenth Amendment since the entire award was unrelated to lost wages or earnings, but were, instead, payments for the restoration of the taxpayer’s human capital. Thus, the entire $70,000 was excludible from income. However, in late 2006, the court vacated its opinion and set the case for rehearing. Upon rehearing, the court reversed itself and held that even if the taxpayer’s award was not “income” within the meaning of the Sixteenth Amendment, it is within the reach of the power of the Congress to tax under Article I, Section 8 of the Constitution. In addition, the court reasoned that the taxpayer’s award was similar to an involuntary conversion of assets – the taxpayer was forced to surrender some part of her mental health and reputation in return for monetary damages.” Murphy v. Internal Revenue Service, 493 F.3d 170 (D.C. Cir. 2007), reh’g. den., 2007 U.S. App. LEXIS 22173 (D.C. Cir. Sept. 14, 2007), cert. den., 553 U.S. 1004 (2008).
What About Lost Profit?
In many lawsuits, there is almost always some lost profit involved, and recovery for lost profit is ordinary income. See, e.g., Simko v. Comm’r, T.C. Memo. 1997-9. For recoveries in connection with a business, if the taxpayer can prove that the damages received were for injury to capital, no income results except to the extent the damages exceed the income tax basis of the capital asset involved. The recovery is, in general, a taxable event except to the extent the amount recovered represents a return of basis. Recoveries representing a reimbursement for lost profit are taxable as ordinary income.
What if Contingent Fees are Part of an Award?
If the amount of an award or court settlement includes contingent attorney fees, the portion of the award representing contingent attorney fees is includible in the taxpayer’s gross income. Comr. v. Banks, 543 U.S. 426 (2005), rev’g and rem’g sub. nom., Banks v. Comr., 345 F.3d 373 (6th Cir. 2003). For fees and costs paid after October 22, 2004, with respect to a judgment or settlement occurring after that date, legislation enacted in 2004 provides for a deduction of attorney’s fees and other costs associated with discrimination in employment or enforcement of civil rights. I.R.C. § 62(a)(19).
Interest on Judgments
Statutory interest imposed on tort judgments, however, must be included in gross income under I.R.C. § 61(a)(4), even if the underlying damages are excludible. See, e.g., Brabson v. United States, 73 F.3d 1040 (10th Cir. 1996).
Under I.R.C. § 104(a), amounts received under workmen’s compensation as compensation for personal injuries or sickness are excludible. However, the exclusion is unavailable to the extent the payment is determined by reference to the employee’s age or length of service.
The Causation Issue
It’s important to determine whether payments received are for physical injury resulting from emotional distress or whether the payments received are for emotional distress resulting from physical injury. This key point on causation was at issue in a recent case decided by the Tax Court. In Collins v. Comr., T.C. Sum. Op. 2017-74, the petitioner sued his employer for workplace discrimination and retaliation, alleging that he “suffered severe emotional distress and anxiety, with physical manifestations, including high blood pressure.” The parties settled the case with the employer paying the petitioner a settlement amount of $275,000 that included an $85,000 allocation to “emotional distress.” The petitioner excluded the amount from his taxable income on his return, but the IRS denied the exclusion.
The Tax Court agreed with the IRS. The court noted that I.R.C. §104(a)(2) excludes from gross income damages paid on account of physical injury or sickness. However, the court noted that this Code section also says that emotional distress, by itself, does not count as physical injury or sickness. Thus, damages paid on account of emotional distress are not excludible. The court noted the legislative history behind I.R.C. §104(a) states that the Congress “intended that the term emotional distress includes symptoms (e.g., insomnia, headaches, stomach disorders) which may result from such emotional distress.” However, the court also noted that Treas. Reg. §1.104-1(c)(2) states that emotional distress damages “attributable to a physical injury or physical sickness” are excluded from gross income. Thus, the court noted that if emotional distress results from a physical injury any resulting damages are excluded from gross income. However, if the physical injury results from emotional distress, damage payments are not excludible. In this case, the petitioner’s damage payment was paid on account of emotional distress that then caused physical injury and were not excludible.
Farmers and ranchers end up in litigation just like non-farmers and ranchers. In many instances those cases settle out-of-court. Sometimes those settlement amounts are significant. That makes the proper understanding of the tax treatment of the settlement award important. When cases don't settle and a judgment is obtained, it's still important to understand the tax consequences.