Settling a lawsuit: do you have to pay the IRS?

Tips on Taxes

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by Brian C. Bernhardt

This column is the first in a series on business tax issues. If you have suggestions for additional topics, please feel free to .(JavaScript must be enabled to view this email address).

Plaintiffs are often unsure whether they must pay taxes on settlement proceeds. Plaintiffs especially care if they pay their attorney a percentage of the recovery - between lawyer fees and income taxes, plaintiffs may not have much left for themselves. Defendants, such as business owners, care because it helps guide the settlement process towards a mutually acceptable settlement range.

Section 104 of the Internal Revenue Code describes the basic rules for determining whether a settlement is taxable. The most common type of settlements addressed by Section 104 are those for “personal injuries” - someone did something to someone else and there is a lawsuit. Under Section 104, plaintiffs do not have to pay taxes on the money they receive in a settlement if they receive the money on account of personal “physical” injuries or “physical” sickness.

In general, this means plaintiffs must suffer an actual physical injury to their body. For instance, automobile accidents, assaults, food poisoning and slip and fall claims often result in physical injuries or sickness. However, law specifically says plaintiffs who suffer only emotional distress and related physical symptoms, such as insomnia, headaches and stomach disorders, have not suffered a physical injury or sickness. In addition, plaintiffs who suffer from employment discrimination, slander and defamation have not suffered a “physical” injury or sickness.

Sometimes, however, plaintiffs suffer from multiple types of injuries. Perhaps a plaintiff has a combination of physical and emotional injuries. Sometimes employment claims (such as sexual harassment) may have a physical aspect. In these types of cases, if a plaintiff suffers any physical injury, then the plaintiff does not have to pay taxes on the settlement proceeds received on account of the physical injury. As a result, while a plaintiff must pay taxes when receiving a settlement for a claim that relates only to emotional distress, a plaintiff does not have to pay taxes when receiving a settlement for a claim that relates to emotional distress caused by physical injury or physical sickness.

A few other notes are also important. These rules apply to damages received for winning a lawsuit, not just to payments received for settling a lawsuit. They also apply to claims settled before filing a lawsuit. Finally, plaintiffs will generally have to pay taxes when they receive punitive damages.

So what to do?

First, understand the claim. The claim will indicate whether it is for a physical injury. For instance, if a claim is for age discrimination, then it is not physical and the plaintiff will pay taxes on any money received. On the other hand, if the driver of a company-owned car hits a pedestrian, the claim is physical and the plaintiff will not pay taxes on any money received. In cases of emotional distress, it is important to determine whether the emotional distress resulted from a physical injury.

Second, during settlement, the parties can specifically allocate settlement proceeds among claims in a favorable manner. Allocation creates arbitrage. By allocating more of the settlement to physical injuries and less to nonphysical injuries, defendants may be able to settle cases for less while insuring that plaintiffs receive more than they would otherwise. Proper allocation allows for the type of win-win situation that encourages settlement and lets everyone move on with their life. The parties cannot allocate, however, unless they understand the claims.

Next month: Payments to lawyers, even those for the benefit of other parties (such as settlement payments), may require notification to the IRS.


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