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.