Wednesday, July 31, 2019
My blog article of July 17 concerning the tax treatment of settlements and court judgments raised an interesting question by a reader. For review, you can read that post here: https://lawprofessors.typepad.com/agriculturallaw/2019/07/tax-treatment-of-settlements-and-court-judgments.html. The reader wanted to know how the tax rules would apply to the Roundup jury verdict that was reached this past May.
Applying the tax Code rules to the Roundup jury verdict (and others) - that’s the topic of today’s post.
Review of the Applicable Rules
As I noted in the July 17 article, proper categorization of a court award or settlement amount is critical. 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). 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. However, recoveries representing punitive damages are taxable as ordinary income regardless of whether they are received on account of personal injury or sickness.
Tax Application to the Roundup Jury Verdict
Impact on the plaintiffs. In May, Alva and Alberta Pilliod a California jury awarded $2 billion in punitive damages and $55 million for pain and suffering as a result of their use of the common weed-killer, Roundup. From accounts that I have read and persons that I have talked to, it is estimated that if the award stands up on appeal (no sure thing), attorney fees would amount to nearly $1 billion. So, how would the tax rules apply to the total award? What would be the Pilliod’s “take-home” amount from the jury award?
It’s important to segregate the jury award for pain and suffering from the award for punitive damages. For starters, the $55 million in pain and suffering is tax-free because it is to compensate for physical injury and/or physical sickness. As for the $2 billion, that's a different story – that amount is fully taxable. So how does this break-out on the tax return? Assuming that this is the only income that the Pilliod’s have for 2019, consider the following:
At the federal level, the $2 billion would be subject to the highest marginal income tax rate of 37 percent, yielding a tax of $740,000,000. There would be a very slight off-set for the standard deduction.
Added to the $740,000,000 of federal income tax is the California state income tax. The state-level tax is a bit more complicated to compute. The top marginal rate of 12.3 percent would apply. To that top rate, an additional 1 percent “millionaire tax” is added. A taxpayer with California taxable income (i.e. as calculated on Form 540, Line 19) exceeding $1,000,000 during a given tax year is subject to the “Mental Health Services Tax.” The amount of the tax is 1% of the amount of the taxpayer’s income that exceeds $1,000,000.
However, California does not couple with the federal government on the issue of the non-deductibility of legal fees. As a result, taxable income for California tax purposes will be substantially less than taxable income at the federal level. Based on a “mocked-up” California tax return, the following results:
Gross income: $2,000,000,000
Deduction for legal fees: 857,341,000
Taxable income: $1,142,659,000
Applying the top California tax rate to the $1,142,659,000; adding in the “Millionaire’s tax” and state-level alternative minimum tax; and factoring in the standard deduction for a married couple, the result is a state-level tax of $151,416,590.
Thus, the total tax bite (federal and state) for the Pilliod’s will be approximately $851,416,590 – very close to one-half of the punitive damage award.
The Pilliod’s will also be responsible for paying attorney fees. If the accounts are correct that the amount will approach the $1 billion amount, the remaining balance of the punitive damage award that the Pilliod’s will actually pocket will be somewhere between $149,000,000 and zero.
Application to the attorneys. The attorneys involved will also have to pay tax on the amount received from the settlement. This is income that is received in the ordinary course of a trade or business, so the amount is subject to tax at the federal and state levels and is also subject to self-employment tax, payroll tax, etc.
Assuming that the attorneys receive $1,000,000,000 in fees, here’s how the tax impact breaks out:
Fed. tax rate of 37%: $370,000,000
CA tax rate of 13.3%: $133,000,000
Total tax: $503,000,000
Balance remaining: $497,000,000
Less s.e. tax; payroll tax; medicare tax, etc. – (assuming 7%: $38,081,260)
Final balance remaining: $458,918,740
In summary, of the total jury award of $2,055,000,000, the total taxes paid (federal and state) amounts to $740,000 + $151,416,590 + 541,081,260, for a total tax bite of $1,432,497,850. That’s an effective rate of 71.6%! The Pilliod’s “take-home” is the $55,000,000 of actual damages and somewhere between zero and $149,000,000 of the punitive damage award. The attorneys “take-home” is $458,918.740. On balance the plaintiffs pocket approximately 2-10 percent of the total award, the attorneys pocket approximately 19-29 percent of the total award, and the government somewhere in excess of 70 percent.
What About Syngenta Payments?
Corn farmers participating in the nationwide class action against Syngenta may begin receiving settlement payments in 2020. None of those payments are attributable to physical injury or sickness. Instead, they are related to market damage/loss. Thus, the settlement payments are fully taxable, and any attorney fees will not be deductible on the federal return.
The taxation of court awards and settlements can be surprising. In addition, the inability to deduct legal fees post-TCJA enhances the tax impact.