16 Taxation and Settlements

Clients generally receive a Form 1099 (or a Form W-2) for the receipt of settlements and attorney fees in personal injury and employment law cases. Many clients say they were informed by their attorney that the settlement proceeds would be tax-free. Unfortunately, this information may be incorrect and subject a taxpayer to a large tax debt.

To determine the income- and employment-tax consequences of a settlement, one must break the settlement down into its various elements. Unfortunately, personal injury attorneys often do not consider the tax ramifications of settlements and may only state a lump sum in the settlement agreement, without breaking the award down into categories. It may be useful to request and review negotiation letters or other communications to see how the lump sum amount was figured. The IRS Chief Counsel has issued a helpful memorandum on how the IRS analyzes settlements to determine tax liabilities.1

When determining which portions of a settlement are taxable income, courts look first to the language of the settlement agreement to determine the purpose of the settlement payments. However, the settlement’s characterization or division of the settlement amounts does not bind the IRS or the courts.2  Courts will look at the economic realities of the settlement. If the settlement lacks express language identifying the purpose of the settlement payments, the courts look beyond the agreement for other evidence of the payor’s intent.3  The complaint and details surrounding the litigation may shed light on the purpose of the settlement.

Settlement of employment law claims are taxable income unless the taxpayer proves an exclusion from income. Under I.R.C. § 104(a)(2), settlements or judgments on employment claims generally may be excluded if the underlying cause of action is tort-based and damages were received on account of personal physical injury or physical sickness.4

Generally, back pay and emotional distress damages are taxable income.5  Stomachaches and headaches may be viewed as symptoms of emotional distress rather than physical injury.6  Emotional distress incurred as a result of physical injury may be excluded.7  Exacerbation of a physical injury by a hostile and stressful work environment may be excludable.8  Payments for medical care to treat emotional distress may be excluded from income up to the amount of medical expenses relative to the emotional distress if not previously deducted under I.R.C. § 213.9

Legal fees in employment law actions should not be taxable because they can now be deducted as an adjustment to gross income.10  However, the deduction for legal fees should not exceed the taxable amount of the settlement. Also, if the entire settlement is excludable under I.R.C. § 104(a)(2), the taxpayer may not deduct the attorney fees.11  The part of a settlement allocable to attorney fees does not constitute “wages” for the purposes of employment taxes.12

If the settlement agreement fails to specify that parts of the settlement were for physical injury or physical sickness, the client may be liable for income and employment taxes on the settlement. Legal fees, interest, physical injury and emotional distress damages are not subject to employment taxes. The IRS considers “front pay” to be wages. However, the Fifth Circuit has held that “front pay” is not wages for the purposes of employment tax.13  To avoid employment taxes, a settlement should clearly indicate the amount attributable to wages, the nature of the wages, and the amount for other payments.14

The IRS now considers severance pay to a terminated employee as income subject to both income and employment taxes.15  However, it is unclear whether severance pay is subject to employment tax.16

• 1Off. of Chief Couns., Internal Revenue Serv., FILES-102495-07, Income and Employment Tax Consequences and Proper Reporting of Employment-Related Judgments and Settlements (2008).
• 2Vincent v. Comm’r, T.C. Memo 2005-95.
• 3Espinoza v. Comm’r, 636 F.3d 747 (5th Cir. 2011).
• 4Id.
• 5 Back pay is subject to income and employment tax in year received. Cleveland Indians Baseball Co. v. United States, 532 U.S. 200 (2001). Emotional distress damages are taxable. Espinoza, 636 F.3d 747.
• 6See, e.g., Gibson v. Comm’r, T.C. Memo 2007-224.
• 7I.R.C § 104(a)(2).
• 8See, e.g., Domeny v. Comm’r, T.C. Memo 2010-9.
• 9Wells v. Comm’r, T.C. Memo 2010-5.
• 10I.R.C. § 62 (a)(20), (e).
• 11I.R.C. § 265 (a)(1).
• 12Rev. Rul. 80-364, 1980-2 C.B. 294.
• 13Dotson v. United States, 87 F.3d 682, 689 (5th Cir. 1996).
• 14Rev. Rul. 80-364, 1980-2 C.B. 294.
• 15Rev. Rul. 2004-110, 2004-2 C.B. 960.
• 16Compare In re Quality Stores, 424 B.R. 237 (W.D. Mich. 2010), with CSX Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008).