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Taxation of Settlements and Damage Awards

Tuesday, August 01, 2006

Tony Argiz
  • Tony Argiz
  • CPA*/ABV/CFF, ASA, CVA, CFE, Chairman and CEO
  • targiz@mbafcpa.com
  • (305) 373-5500
Viresh Dayal

Generally, the plaintiff is subject to income tax on the full amount of any settlement or damage award, unless associated with personal physical injury or physical sickness (IRC Section 104 (a) (2)). Punitive damages are taxable. So are damages awarded in cases such as employment wrongful discharge, discrimination and libel. Consequently, many settlements seek to characterize a substantial portion of the settlement as reimbursement for personal physical injury or physical sickness.

Internal Revenue Service will look to the "origin of the claim" and not the mere form of the settlement agree¬ment. If the complaint sought damages under multiple theories, the taxpayer may have to justify to the IRS any sub¬sequent allocation of the award.

Attorney Fees

When damages awards have been tax¬able, plaintiffs sometimes have found themselves owing more in taxes than they actually received from the settle¬ment. In Commissioner v. Banks (2005), the Supreme Court held that, as a general rule, plaintiffs must pay income tax on the amount that is earned by the plaintiff's attorney. The attorney fees could only be deducted as miscellaneous deductions subject to a 2% floor limitation and altogether dis¬allowed as a deduction for AMT (Alternate Minimum Taxes) purposes. The American Jobs Creation Act of 2004 changed the law for actions involving a claim for "unlawful dis¬crimination," which includes a number of specific federal statutes and any fed¬eral, state, or local law regulating any aspect of the employment relationship or prohibiting the discharge of an employee. Plaintiffs with employment- related claims can now claim an "above the line" tax deduction for the attorney fees paid after October 22,2004.

Business Damages

Damages received for injury to business as compensation for lost profits are taxable as ordinary income. This applies to awards for breach of a con¬tract of sale and for business slander. Amounts received for injury to capital (e.g., injury to good will, fraudulent stock sale) are tax-free to the extent of basis; any excess is capital gain.

New rules for Tax Withholdings

Under two recently released Revenue Rulings (2004-109 and 110), awards will have to be treated as employee "wages" if the payment has anything to do with the "establishment, maintenance, further¬ance, alteration, or cancellation of the employer-employee relation." The result is that many damage awards will have to be characterized as wages. Income tax withholding at 25% for federal (plus state, city and municipality taxes) and employer and employee FICA taxes and FUTA taxes must be deducted and paid. There are significant adverse conse¬quences for non-compliance.

New rules for Tax Withholdings

Under two recently released Revenue Rulings (2004-109 and 110), awards will have to be treated as employee "wages" if the payment has anything to do with the "establishment, maintenance, further¬ance, alteration, or cancellation of the employer-employee relation." The result is that many damage awards will have to be characterized as wages. Income tax withholding at 25% for federal (plus state, city and municipality taxes) and employer and employee FICA taxes and FUTA taxes must be deducted and paid. There are significant adverse conse¬quences for non-compliance.