September 08, 2016 Articles

A Primer on the Tax Consequences of Settlement Payments

By Julia Mandeville Damasco and Margaret Trollan

The tax character of payments made in settlement of legal and equitable claims directly impacts the value of settlement dollars, making tax implications important to all advocates. Those implications are often within your control, because the language of a fee agreement, complaint, settlement agreement, or judgment is an important factor driving the tax consequences of a settlement payment.

In United States v. Gilmore, 372 U.S. 39 (1963), the Supreme Court held that the origin of the claim controls the tax treatment of any resulting recovery, whether received pursuant to a settlement or a judgment. Id. at 49. When a payment represents more than one type of recovery, however, the U.S. Tax Court has held that the allocation among recovery categories in a settlement agreement itself is generally binding for tax purposes to the extent that the parties entered into the agreement in an adversarial context, at arm’s length, and in good faith. Where the intent of the parties is not articulated, however, the default tax characterization based only on the claim is often not desirable. The bottom line: drafting is important, not only because you should be aware of the tax consequences of a particular settlement for your client, but also because settlement dollars are worth more to a plaintiff when they are excluded from income or enjoy a tax preferred status.

A full-scale explanation of all tax consequences associated with settlement payments is far beyond the scope of this article. Instead, this article outlines some basic tax issues associated with settlement payments to make you aware of how complex these issues can be.

Characterizing Recovery Payments Based on the Origin of the Claim
Whether a settlement payment made to cure an alleged harm—i.e., a recovery payment—qualifies as taxable income depends on the type of legal or equitable claim that the payment is designed to redress. For example, wages are the presumed tax character of payments made to settle most employment-related litigation, and exceptions to this general rule are construed narrowly. Given this general rule, other components of recovery must be overtly identified in a settlement agreement, judgment, or similar document, and evidence in the record is required to support an exception created by the parties’ express allocation. Importantly, payments that would have been tax preferred if made according to the rules establishing the tax preference are not tax preferred when made to resolve a dispute about the failure to make the payment. Payments that lose tax preferred status include retirement plan contributions and employee expense reimbursements. Recent attempts to secure contrary rulings suggest that the IRS will continue to cite LTV Steel v. United States, 215 F.3d 1275 (Fed. Cir. 2000), as authority for such a wage characterization. A close reading of LTV Steel suggests narrowing the scope of payments treated as wages, but the IRS has not yet accepted that interpretation.

In contrast to recovery payments in employment cases, recovery related to a claim involving a capital investment is usually a return of capital and is not reportable as taxable income. As a result, there may be tax benefits associated with allocating settlement dollars as associated with damage to a capital asset, the return of mortgage interest (assuming the mortgage interest amount was not originally included as an itemized deduction), and/or general damages for a violation of a banking law or a civil right. Specifically, these allocations will serve to increase the value of settlement dollars flowing to recipients and reduce administration burdens in a class or enforcement case. Proper drafting substantially impacts the tax result in mortgage practices, securities, and other litigation involving capital assets and investments, as seen in IRS Revenue Ruling 2014-2. The positive result for the borrowers in the National Mortgage settlement explained in that ruling was made possible by the parties’ artful drafting.

In personal injury cases, settlement money received “on account of personal physical injuries or physical sickness” does not qualify as taxable income. See I.R.C. § 104. Indeed, even a settlement payment associated with emotional distress will not be taxable as long as that distress flows from a physical injury. The nuance associated with emotional distress–related payments, however, requires attention. Complex timelines and fact patterns provide an opportunity equally advantageous to plaintiff’s and defense counsel to allocate specific dollars to specific time periods. For example, a period of time where unwelcome touching caused no physical injury but did cause emotional distress and a period of time where a subsequent assault caused physical injury, emotional distress, and medical expenses should be expressly distinguished in settlement documents for the best tax outcome. It is better to articulate the allocation in a settlement document than to leave it up to the IRS.

Characterizing Interest Payments
Interest is always income. In West Virginia v. United States, 479 U.S. 305 (1987), the Supreme Court held that notwithstanding the authority of the courts to award prejudgment interest as an item of damages, its nature as “interest” remains constant. Id. at 310. Treating interest as income does not necessarily result in a negative tax outcome, however. In a case where 1,500,000 members of a class receive a payment composed of ordinary income and interest income, the 1099 reporting thresholds may operate to reduce the number of tax reporting forms required and thereby reduce the administration costs of the settlement by dividing each payment between income reportable on a 1099-MISC and a 1099-INT. If the reporting threshold is not reached for one or both of these forms, then no reporting is required. A similar result is reached with greater impact on the value of settlement dollars where recovery is allocated between wages, 1099-MISC income, and 1099-INT income.

Characterizing Attorney Fees Payments
Attorney fees paid by a third party are generally considered reportable income to the plaintiff and the attorney. See I.R.C. § 61; Comm’r v. Glenshaw Glass Co., 348 U.S. 426 (1955); Old Colony Trust Co. v. Comm’r, 279 U.S. 716, 723 (1929); Banks v. Comm’r, 345 F.3d 373 (6th Cir. 2003); Banaitis v. Comm’r, 340 F.3d 1074 (9th Cir. 2003); Sinyard v. Comm’r, 76 T.C.M. 654 (1998), aff’d, 268 F.3d 756 (9th Cir. 2001). Some cry double reporting and double taxation because in many cases, the result is that the fee payment is taxed twice or almost twice.

Two exceptions exist to the general rule that attorney fees payments are income to the client. First, attorney fees are not income where the underlying recovery payment is not taxable, such as physical injuries under I.R.C. section 104. Second, money paid to compensate class counsel from a common fund is not income to the class members in an opt-out class action. In 2002, IRS Chief Counsel Advice 200246015 specifically explained that legal fees paid directly to class counsel are not income, profits, or gain to a taxpayer if: (1) the taxpayer does not have a separate contingency fee arrangement with the class counsel, and (2) the class action is an opt-out class action. The IRS emphasizes that the inquiry turns on whether an individual class member has an enforceable fee agreement with class counsel but informally acknowledges this as an unsettled area of law.

In actions based on civil rights or employment claims, a taxpayer may take a deduction for an attorney fee award attributed to the taxpayer as income in determining his or her adjusted gross income irrespective of whether the taxpayer itemizes deductions or takes a standard deduction. The attorney fee is also deductible for alternative minimum tax purposes. The fee attributed to the taxpayer is no longer treated as a miscellaneous itemized deduction, and there is no other adjustment or preference that would require the fee to be added back.

Given the generally taxable nature of attorney fees payments, recipients of such fees frequently attempt to delay their receipt. The IRS, courts, and state bars have created rules governing attorney fees payments structured for that purpose. Among those rules, the rules articulated in Childs v. Commissioner, 103 T.C. 634 (1994), remains the leading authority. The IRS has summarized the holding in Childs as follows: “[W]here attorneys entered into a structured settlement which called for deferred payments of their fee, and the settlement was entered into prior to obtaining an unconditional right to compensation for their legal services, the court held that they had not constructively received income upon the purchase of the annuity contracts meant to provide payments for the legal services fee.” Field Service Advice 200151003 (July 5, 2001) (emphasis added).

Under Childs, the correct way to defer the income realized as a result of a fee award is quite simple: Counsel must enter into an irrevocable agreement for periodic payments, or the court must issue an order that requires periodic payments of counsel’s fee; and the settlement must be entered into or the order issued prior to counsel’s obtaining an unconditional right to compensation for his or her legal services. The timing matters.

Reporting Requirements
There are new rules about reporting payments and requesting information. Generally, payments made to corporations are excluded from 1099 reporting unless they are medical and health care payments, attorney fees, gross proceeds paid to an attorney, or other specified payments. The Internal Revenue Code no longer allows for an “eyeball” test for determining which entities qualify as corporations for the purpose of the corporate reporting exemption, however. That is, a payer may no longer rely on the name of a corporation for purposes of applying the corporate exclusion from 1099 reporting. A payer must request W-9 forms from corporations and may only exclude payments to them based on their status as a corporation if a valid W-9 form is received. There are other new rules beyond the scope of this article. A good practice is to request W-8 or W-9 forms from all recipients of payments.

Collecting information from recipients of payments raises issues beyond tax compliance. In order to comply with the proper reporting of payments flowing from settlements and judgments, it is necessary to collect personal information. All of this information is also personally identifiable information (PII). The United States has no omnibus federal law regulating the collection and use of personal data; rather PII protection is regulated by many different laws. For example, the Federal Trade Commission Act prohibits unfair or deceptive practices and has been applied to offline and online privacy and data security policies. The Financial Services Modernization Act (Gramm-Leach-Bliley Act) regulates the collection, use, and disclosure of financial information. And the Health Insurance Portability and Accountability Act (HIPAA) regulates medical information. Be aware of federal and other state laws that regulate the use, storage, and collection of PII in the settlement context. Best practices include the following:

    1. Require secure storage of information in a location subject to the jurisdiction of the United States for U.S. cases.

    2. Protect from disclosure the information that is not required to effect the payments.

    3. Protect the data during electronic transmission.

    4. Provide for the secure and documented destruction of data.

OFAC Requirements
Making payments requires activities beyond tax compliance and protecting personal data. The United States Department of the Treasury’s Office of Foreign Assets Control (OFAC) is charged with ensuring that payments made in any circumstances follow the United States’ current sanctions policies. OFAC requires all entities involved in settlements—law firms, attorneys, individuals, insurers, and settlement funds—to comply with OFAC regulations. This means that names of payment recipients must be compared to OFAC’s “Specially Designated Nationals” list.

Examples to Illustrate Tax Issues

Example 1: Let’s assume that the defendant agrees to pay $1,000,000 to the plaintiff in exchange for an unconditional release of the plaintiff’s claim for unpaid wages, interest, penalties, and attorney fees and costs. In this case, the underlying claims and statutes provided for waiting time penalties and interest on any claim for unpaid wages.

Under the terms of this settlement, the failure to allocate the settlement payment among wages, interest, and penalties results in wage characterization of the entire payment exclusive of the attorney fee award. Some IRS field personnel would also characterize the attorney fee award as wages. The attorney fee is correctly reported as nonwage income to the plaintiff and deductible by the plaintiff, above the line.

Example 2: Let’s assume that the defendant agrees to pay $500,000 to the plaintiff for violation of the plaintiff’s civil rights, $250,000 to the plaintiff as a return of overpaid mortgage interest, and $200,000 as recovery for emotional distress. The defendant will also pay attorney fees and costs in the amount of $300,000.

Under the terms of this settlement, $700,000—the $500,000 recovery payment and $200,000 emotional distress payment—is reported as ordinary income on a form 1099 MISC. The $250,000 return of mortgage interest is reported on a form 1098. An information return is properly delivered to both the plaintiff and the attorney for the $300,000 attorney fee payment.

Because this case involves a civil rights claim, the plaintiff will be able to deduct the $300,000 attorney fee payment. The $250,000 return of mortgage interest may or may not be income in the hands of the plaintiff depending on whether the originally paid mortgage interest was deducted as a miscellaneous itemized deduction.

Example 3: Let’s assume that the defendant agrees to pay $800,000,000 into a fund established to resolve claims of fraud in the sale of securities. Each injured investor shall receive a payment based on the number of shares purchased allocated between interest and loss of the value of the shares purchased. Each payment shall be allocated one-half to interest and one-half to the loss of share value. No information returns shall be sent to the injured investors or to the tax authorities.

Under the terms of this settlement, one-half of the payments made to injured investors are reportable as interest income on form 1099 INT. The remaining half is not reportable to either natural persons or entities because it is a return of capital.

The statement in the example agreement that no information returns will be sent, even when blessed by a court, is not dispositive. The IRS and state tax authorities are not parties to the litigation and are not bound by the court order or the parties’ agreement. Failure to comply with the information reporting obligations associated with these payments subjects the payer (usually a defendant or a qualified settlement fund) to substantial penalties.

This article is intended only to provide a high-level review of some of the tax consequences that may flow from settlement payments, and to encourage you to consult with tax counsel and to be aware of the ways in which tax consequences may allow you to achieve a more favorable settlement for your client.

Keywords: litigation, woman advocate, settlement, negotiation, tax consequences, recovery, attorney fees, interest payments

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