A Practice Smart(TM) Feature
By Robert W. Wood
Robert W. Wood practices law with Wood LLP in San Francisco and is
the author of Taxation of Damage Awards and Settlement Payments
(4th ed. 2009 with 2012 supplement), Qualified Settlement Funds and Section
468B (2009), and Legal Guide to Independent Contractor Status (5th ed. 2010).
You’ve been done wrong. You win damages. Now Uncle Sam may want a cut.
Your car got rear-ended; you were fired unfairly; your contractor did shoddy work on your condo. Now you’re due some money and wondering if Uncle Sam will demand a cut. The answer varies—depending on how you were damaged, how the case was resolved and more. So it pays to know a little about taxes on damages before you
negotiate a settlement
Physical injury awards are tax free
Damages for personal physical injuries (say, broken bones from an accident) are tax free, although punitive damages and interest paid on an injury award are taxable. Damages for emotional injuries are taxable. Physical symptoms caused by emotional distress—say, headaches—are generally taxable, but it’s fuzzy and much litigated. Last year, for example, the U.S. Tax Court overruled an Internal Revenue Service decision to tax a
$350,000 settlement a Maryland man received after suing his ex-employer for intentional infliction of emotional distress. Why? The distress arguably led to a real disease—a heart
attack—the court said. Note, too, that payments for medical treatment, including counseling, aren’t taxable.
How you settle can matter
You have more flexibility to reduce taxes if you settle, especially if you negotiate with an eye on the tax rules. So an agreement might say all the cash was for a (nontaxable) physical injury, while a court verdict might attribute some of it to taxable punitive damages or interest. (The IRS isn’t bound by an agreement’s wording, but it can help.)
Lose a job, pay the IRS
Severance pay is taxed and treated as wages, subject to tax withholding and payroll taxes (Social Security and Medicare), even though you no longer work at the company. Damages for discrimination are taxed as ordinary income, too, but not as wages—so you don’t owe payroll tax. Emotional suffering from discrimination? Taxable—unless, for example, it gives you a heart attack. Outplacement and help with health insurance
premiums (if paid directly to the insurer) aren’t taxed.
Property damages can be tax free
If an auto crash payment or settlement from your contractor merely pays for the cost of fixing your car or condo, it’s a “recovery of basis” and tax free, provided you don’t get back more than you paid for the car or condo (and haven’t claimed a casualty deduction
for damage to the property). If the damage is to your business or factory, the same rules apply—although a recovery in excess of your basis might be taxed at the 15% capital gains rate.
Attorney fees can be a tax trap
Attorney fees in a business case are deductible as a business expense. In a personal case, watch out. The tax law treats you as receiving 100% of the settlement, even if the defendant issues a separate check to the lawyer for his cut. If your damages aren’t taxable, that’s no problem. A 2004 law makes attorney fees for discrimination awards deductible “above the line”—so they won’t affect your tax bill. But in other nonbusiness suits, attorney fees count as a miscellaneous itemized deduction, meaning the alternative minimum tax and other gotcha tax provisions could leave you paying tax on money your attorney received. Another reason to talk to a tax expert before you sign any settlement.
Originally published by Forbes Magazine. Copyright 2012 Robert W. Wood. All rights reserved
The information in this article is provided for informational purposes only and with the understanding that the author is not engaged in rendering legal, accounting, tax or other professional advice or services. The discussion is not intended as legal advice and cannot be relied on for any purpose without the services of a qualified professional.
Practice Smart(TM) Features are a service of Michael Blum and Appeal Funding Partners, LLC. The Features are thoughts from a variety of sources on our practices, on being trial lawyers and things of importance to trial lawyers and their clients.
Michael Blum is a trial attorney and CEO of Appeal Funding Partners, LLC with over 17 experience easing the financial hardship and stress of attorneys and plaintiffs with money judgments on appeal. He has served on the Board of Directors of the Consumer Attorneys of California and of the Marin Trial Lawyers Association and is an active member of the American Association for Justice. He regularly speaks to trial-lawyer groups and has written for TLA publications on the financial management of a contingency-fee law firm. He may be contacted at 415-729-4214.
If you would like to be informed of these Articles, please CLICK HERE to fill in your details.