Taxation of Settlements and Judgments: Understanding the Complexities

In the ordinary course of business, it is not uncommon for individuals and organizations to find themselves involved in litigation or arbitration. As a result, settlements and judgments can occur, which may have significant tax implications. However, these implications are often overlooked or misunderstood. Understanding the federal tax treatment of settlements and judgments is crucial for both the payer and the recipient.

Determining Tax Treatment: The Origin of the Settlement Claim

The proper tax treatment of a settlement or judgment largely depends on the origin of the claim. Courts often consider the question "In lieu of what were the damages awarded?" to determine the appropriate payment characterization. This characterization determines whether the payment is taxable or nontaxable and, if taxable, whether ordinary income or capital gain treatment is appropriate.

For recipients of settlement amounts, damages received as a result of a settlement or judgment are generally taxable. However, certain damages may be excludable from income, such as payments for personal physical injuries, amounts previously not taxed, cost reimbursements, recovery of capital, or purchase price adjustments. The tax treatment may also vary depending on whether the damages relate to a claim for lost profits or damage to a capital asset.

On the other hand, for the payer, the tax treatment depends on whether the payment is deductible or nondeductible, currently deductible, or required to be capitalized. Payments arising from personal transactions may be considered nondeductible personal expenses. In contrast, payments arising from business activities may be deductible under specific provisions of the Internal Revenue Code. It is important to note that certain payments may be nondeductible or be required to be capitalized.

The Burden of Proof and Evidence

Taxpayers bear the burden of proof for the tax treatment and characterization of a litigation payment. The language found in the underlying litigation documents, such as pleadings or a judgment or settlement agreement, is often crucial in determining the tax treatment. Supporting evidence includes legal filings, settlement agreement terms, correspondence between the parties, internal memos, press releases, annual reports, and news publications.

Tip: While various pieces of evidence can be persuasive, the Internal Revenue Service (IRS) generally views the initial complaint as the most persuasive. As such, attorneys need to be cognizant of the tax implicants of claims made in the initial filings.

Allocating Damages

When a settlement or judgment encompasses multiple claims or involves multiple plaintiffs or defendants, allocating damages becomes essential. Factors such as who made and received the payment, who was economically harmed or benefited, against whom the allegations were asserted, who controlled the litigation, and whether costs/revenue were contractually required to be shared are critically important. Also, joint and several liabilities are necessary considerations when determining the allocation.

Settlement agreements or judgments may provide for a specific allocation. The IRS generally accepts these ordered allocations. However, the IRS may challenge the allocation if the facts and circumstances indicate that the taxpayer has another purpose for the allocation, such as tax avoidance. Taxpayers, not the IRS, have the burden of proof when defending the allocation in proceedings with the IRS.

Deduction Disallowances

Certain deduction disallowances apply to payments and liabilities resulting from a judgment or settlement. The Tax Cuts and Jobs Act (TCJA) introduced changes to the Internal Revenue Code that disallow deductions for certain payments.

Under Section 162(f) as amended by the TCJA, deductions are disallowed for amounts paid or incurred in relation to a violation of law or an investigation or inquiry into a potential violation of law. However, there are exceptions for restitution, remediation, or compliance with the law, taxes due, and amounts paid under court orders when no government or governmental entity is a party to the suit. Recent regulations further clarify the disallowance, specifying that routine audits or inspections unrelated to possible wrongdoing are not subject to the disallowance.

Another deduction disallowance introduced by the TCJA is found in Section 162(q). This provision disallows deductions for settlements or payments related to sexual harassment or abuse subject to a nondisclosure agreement. However, it is essential to note that the disallowance does not apply to the attorneys' fees incurred by the victim.

Additional deduction disallowances include those under Section 162(c) for illegal bribes and kickbacks, and Section 162(g) for treble damages related to antitrust violations.

Qualified Settlements Funds

Established under §1.468B-1 et seq., a Qualified Settlement Fund (QSF) offers a wide variety of tax and financial planning benefits and flexibility that would not otherwise be available to a plaintiff if the settlement or judgment is paid directly to the plaintiff or their attorney.

See this link to learn more about QSFs.

The Banks v Commissioner Double Taxation Problem

Plaintiffs often keep less than half of what they should. A Plaintiff pays tax on winnings he or she keeps, and also pays tax on the portion of the winnings paid to his or her lawyer – who then again pays tax on the same money. The Plaintiff Recovery Trust avoids the Double Tax, often increasing net recoveries by 50%-150%.

See how to solve the double taxation problem and pay less taxes with this link to the Plaintiff Recovery Trust.

The Importance of Considering Tax Implications

Taxpayers must consider the tax implications when negotiating settlement agreements or reviewing proposed court orders or judgments. Failure to do so may result in adverse and avoidable tax consequences or loss of tax management opportunities. By understanding the origin of the claim, properly allocating damages, and considering deduction disallowances, taxpayers can navigate the complexities of taxation in settlements and judgments.

Conclusion

The taxation of settlements and judgments is a complex area that requires careful consideration. The origin of the claim, the allocation of damages, and the deduction disallowances all play a significant role in determining tax treatment. Taxpayers must diligently understand the implications and seek professional advice when necessary. By doing so, taxpayers and their advisors can ensure compliance with tax laws and minimize potential tax liabilities.