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Litigation can be stressful; and with such a focus on winning, tax is often the last thing on anyone’s mind. As a result, individuals and their attorneys often fail to consider the tax ramifications of a settlement award until it is too late. Given the current economic landscape, it is more important than ever to consult with a tax professional during pre-settlement negotiations to avoid any unwelcome surprises once the tax bill is due.

Background

Generally, settlement proceeds constitute gross income under the Tax Code. Thus, unless an exclusion applies, the full amount of the award is taxable. Even when an exclusion applies, the IRS must be able to easily trace the award amount to an excludible source.

If selected for examination, the tax authorities will first try to determine the nature of the payments and associated tax treatment by reviewing the terms of the settlement agreement. If the payment is not clearly defined and allocated to a tax-excludible claim or cause of action in the settlement agreement, then the IRS will request a copy of the complaint to draw their own conclusions, which could be detrimental to the taxpayer.

By the time a litigant finally receives that settlement award, they may already be faced with a significant tax liability. However, proper tax planning can be done to determine which amounts, if any, can be excluded from gross income and which fees and costs, if any, can be deducted. In this tax alert, we examine some important tax consequences to keep in mind from the time a claim is filed to the time a settlement agreement is signed.


Income Exclusion for Physical Injury or Physical Sickness

As noted above, a settlement award is generally included in income. However, the amount of any non-punitive damages received on account of personal physical injuries or physical sickness is excluded from gross income.

What is not excluded from gross income? Damages received on account of non-physical injuries or sickness, such as emotional distress or mental anguish. The term “emotional distress” includes any physical symptoms (i.e., insomnia, headaches, stomach disorders) that can result from the distress. Thus, in determining excludability, it is important to determine the origin of the claim. If emotional distress originates from physical injury, then the amounts are excludible; physical symptoms of emotional distress are not.

To ensure excludability, any award for physical injury or sickness should be specifically allocated to that cause of action in the settlement agreement. For example, if the agreement properly allocates $200,000 of an $1,000,000 award to a physical injury claim, then the litigant’s gross income should only be $800,000.


Tax Treatment of Fees and Costs: Limitation on Deduction  

 Prior to the passage of the Tax Cuts and Jobs Act (“TCJA”) in 2017, individuals generally could deduct attorneys’ fees incurred in lawsuits or settlements as a miscellaneous itemized deduction to the extent that the amount exceeds 2% of the taxpayer’s adjusted gross income (“AGI”).

Now, for tax years 2018 through 2025, the TCJA suspends this deduction. As a result, individuals currently cannot deduct attorneys’ fees incurred in lawsuits or settlements as an itemized deduction. Different rules apply to awards received in connection with a case that involves a trade or business.

Notwithstanding the unavailability of a “below-the-line” deduction for attorneys’ fees and court costs, an “above-the-line” deduction is permitted for certain fees and costs incurred by a taxpayer in connection with any action involving a claim of unlawful discrimination. However, the deduction cannot exceed the amount includible in the taxpayer’s gross income on account of a judgment or settlement resulting from such claim.


Tax Treatment of Fees and Costs: Contingency Fees Included in Income

In Comm. v. Banks (2005), a U.S. Supreme Court held that plaintiffs must include in gross income the portion of any award paid to an attorney as a contingent fee. This is the case even when the fees are paid directly by the defendants to the attorney.

As you can imagine, this rule would come as a great shock to litigants who hire lawyers on a contingency fee basis (i.e., personal injury or divorce cases). Notably, this rule does not apply to court-ordered attorneys’ fees; it only applies to fees paid pursuant to a pre-arranged “contingency fee arrangement” under the assignment of income doctrine.

For example, suppose a person is injured in a hit-and-run accident and hires an attorney to represent him. As part of the engagement, the person agrees to pay his attorney 30% of any reward received upon settlement. Let’s further suppose that the court awards the plaintiff $1,000,000, of which $300,000 is paid directly by the defendant to the plaintiff’s attorney. Although the plaintiff would only expect to be taxed on the amount he receives (i.e., $700,000), he might be surprised to find out that the full $1,000,000 must be included in income.

This seemingly inequitable result is particularly significant considering the TCJA’s suspension of the itemized deduction for individuals. If the award was received in, say, 2017, then the plaintiff may be able to deduct the $300,000 attorney’s fees as an itemized deduction.


Summary

Without proper pre-settlement tax planning, litigants may be left struggling to pay taxes on money that they never received. They may also miss out on opportunities to exclude personal injury awards from income or claim an “above-the-line” deduction in certain discrimination suits. Because of changes in the TCJA, litigants should be aware of the potential pitfalls involved in hiring attorneys on a contingency fee basis and plan accordingly.

Before you sign a settlement offer, or even before you consider filing a lawsuit, it is advisable to contact a trusted tax advisor to discuss potential tax ramifications of a settlement award.

For any questions specific to this Tax Alert, please contact any of the following individuals:

 

Name: Meghan Andersson, JD, LLM

Office: Irvine, CA

Phone: (949) 623-0542

Email: mandersson@singerlewak.com

 

Name: Jason Borkes, CPA, CM&AA

Office: Irvine, CA

Phone: (949) 623-0516

Email: jborkes@singerlewak.com

 

Name: Mark Cook, MBA, CPA, CGMA

Office: Irvine, CA

Phone: (949) 623-0478

Email: mcook@singerlewak.com

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