Tax Effects of Settlements and Judgments of Employment ClaimsLangdon Owen
August 28, 2009 — 2,190 views
1. General Principles. In a dispute between an employee and his or her employer, the economic benefits of a settlement or judgment may be importantly affected by the ultimate after-tax results of any payment. This may, in turn, affect how the claim is framed and whether or how a settlement is negotiated. The tax analysis of such matters can thus be of real dollar value to the parties to the dispute. Such analysis starts with some general principles and then moves to more particularized issues. Let's look first at the most important general principles which will affect the analysis.
(a) Income. Gross income includes "income from whatever source derived." Internal Revenue Code ("IRC") § 61. This includes "accessions to wealth." Com'r v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955). Amounts received through judgments or settlements can be income.
(b) Character of Income. Different sorts of payments can receive different treatment for tax purposes. For individuals, capital gain is taxed at different rates than ordinary income. Compensation is ordinary in character, as is interest and punitive damages. Payments for loss of property can be ordinary or capital depending upon the character of the property in the hands of the person whose property was lost. Gail v. U.S., 58 F.3d 580 (10th Cir. 1995).
(c) Exclusions from Income. Some items are statutorily excluded from income. This includes damages received on account of physical personal injury or sickness. IRC § 104(a)(2). Prior to its 1996 amendment (effective generally for payments received after August 20, 1996), nonphysical personal injury amounts were also excluded under this Code Section, but no longer. The "amounts received on account of" language of the Code may be broader than mere compensation for injury; the issue is: how far does this go? The basic policy of IRC § 104 (which may, however, go further if justified by the Code language) is not to tax amounts to make the victim whole in his or her person where the personal asset i.e., health, a body part, etc.) would not be taxed if not lost.
(d) Deductions. Some payments made by a payor are deductible as reasonable, ordinary, and necessary business expense under IRC § 162 or as an expense to produce income, under IRC § 212, and some may be required to be capitalized and deducted over time through depreciation or amortization (e.g., costs of building a capital asset), and some may not be deductible at all (fines and penalties, personal expenses). A similar series of issues applies to the expenses of the claimant in pursuing the claim.
(e) Origin of Claim. With these differences in treatment possible, a principled method of making the appropriate distinctions is needed. This method is to analyze the origin of the claim. Hort v. Com'r., 372 U.S. 39 (1963). The amount received which satisfies the claim of loss is treated the same as the lost item would have been treated, even without the loss. Thus, generally, a wage claim or employment contract payment is taxed as wages (ordinary income), and if the employee was employed in a trade or business, the payment may be deductible by the payor as a business expense (unless required to be amortized by some other tax rule, e.g., in the construction of a building, the making of a movie, or the creation of another form of capital asset). The use of the origin of the claim test is not always easy.
(i) No Specific Allocation - Entire Record. Where there are claims of various kinds raised which result in a single lump sum amount not specifically allocated through an allocation entitled to be respected, the IRS looks to the complaint as the most persuasive evidence of how to characterize the recovery. Rev. Rul. 85-98, 1985-2 C.B. 51 (allocation of settlement proportional to amounts claimed in complaint for compensatory and punitive damages). Also, the courts look to all the facts and circumstances and the entire record where the payor's intent is not clearly discernable by specific allocation under a settlement agreement entitled to be respected. The court generally looks to the payor's intent as to the purpose of the payment-what claims the payor was settling, regardless of the claimant's belief. Agar v. Com'r., 290 F.2d 283 (2d Cir. 1961), aff'g T.C. Memo 1960-21; Stuks v. Com'r., 98 T.C. 1 (1992); Knuckles v. Com'r., 349 F.2d 610 (10th Cir. 1965), aff'g, T.C. Memo 1964-33. See also Robinson v. Com'r., 102 T.C. 116 (1994), aff'd, 70 F.3d 34 (5th Cir. 1995); McKay v. Com'r., 102 T.C. 465 (1994), vac'd, 96-1 USTC ¶ 50,279 (5th Cir. 1996); Barnes v. Com'r., T.C. Memo 1997-25; Bagley v. Com'r., 105 T.C. 396 (1995) aff'd, 121 F.3d 393 (8th Cir. 1997). These cases indicate that the factors to be considered include:
1) details surrounding the proceedings,
2) allegations in the complaint,
3) arguments made by the parties,
4) A court may look first to pleadings, jury awards, court orders, judgments entered before settlement,
5) but where the items described in (4) do not provide guidance, the entire record.
(ii) Specific Allocation in Settlement. A specific allocation in a settlement agreement where the allocation is arrived at in an adversarial context at arms length and in good faith will generally be binding for tax purposes. See the Bagley, McKay, and Robinson cases cited above. See also, Threlkeld v. Com'r., 87 T.C. 1294 (1986), aff'd, 848 F.2d 81 (6th Cir. 1988). The courts will not necessarily respect an allocation made in uncontested, nonadversarial, tax-motivated circumstances. Robinson, op cit. If a claim produces a result that is neutral for the payor so that the payor is indifferent as to the allocation, the courts are free to examine the true nature of the claim intended to be settled by the payor. Bagley, op cit.
2. Personal Injury Exclusion. Although in the past, nonphysical damages in "tort-like claims" (a concept which deeply divided the courts) in employment cases might have been excludable under IRC § 104(a)(2), this is no longer the case. Under the Small Business Job Protection Act of 1996 (P.L. 104-188), IRC § 104(a)(2) was greatly narrowed.
(a) Physical Injury; Cost of Emotional Treatment. Compensation for the injury or sickness is only excludable where the injury or sickness is physical. However, the medical costs to treat emotional distress are excludable even through damages for the emotional distress itself will not be excludable. Physical injuries, however, might include unwanted and uninvited physical contacts which result in observable bodily harms, such as bruises, cuts, swelling, or bleeding. PLR 200041022.
(b) Nonphysical Injuries. Injuries which are not physical do not give rise to excludable damages. Most employment-related causes of action fit in this category, including:
- wrongful termination;
- invidious discrimination on the basis of age, sex, race, etc.;
- constitutional torts - see 42 USC §§ 1981 and 1983;
- loss of reputation;
- Title VII of the Civil Rights Act of 1964;
- emotional distress.
(c) "On Account of" Damages. Although limited to physical injuries, other payments made "on account of" such physical injuries beyond direct compensation for the injury itself may be excludable if the payment is sufficiently connected to the physical injury. The leading case for interpreting the phrase "on account of" is Com'r. v. Schleier, 515 U.S. 323 (1995). The case was decided just before Congress amended IRC § 104 but is still the controlling precedent on the meaning of this phrase. The Court requires a close linking of each element of the damages received to the personal injury in order to justify exclusion. The Court used the example of an auto accident case involving lost wages as a standard against which to compare an employment claim involving back pay. The auto accident causes physical damage which, in turn, causes the pain, suffering, and the lost wages for time away from work. The lost wages are connected to the actual physical injury. However, the Court found that although the employee may suffer similar distress and lost wages as a result of discrimination, these are not connected with each other. The back pay is not measured by time away from work due to the injury itself as it is in the auto accident case where the healing (or lack of healing) of the injury measures the damage. Rather, in the employment case, the time to trial or some other event measures the damage, and this is not a sufficiently close connection to the personal injury itself.
(i) Excludable. In a physical injury case, the exclusion would cover these items:
1) lost wages,
2) medical expense,
3) pain and suffering.
These are excludable even if paid out over a period of time, such as under an annuity purchased by the payor to fund the settlement. IRC § 104(a)(2) now includes the phrase "whether as a lump sum or as periodic payments."
(ii) Not Excludable. Even in a physical injury case, these items are not excludable from gross income:
1) Prejudgment interest would not be excludable because it is for the time value of money, not the physical injury itself. Brabson v. U.S.., 73 F.3d 1040 (10th Cir. 1996), cert. denied, 117 S. Ct. 607 (1996).
2) Punitive damages are not designed to compensate victims but are punitive in nature. O'Gilvie v. Com'r., 519 U.S. 79 (1996), aff'g 66 F.3d 1550 (10th Cir. 1995); see also IRC § 104 which was amended to codify this rule. However, if the punitive damage element is donated to a charitable trust prior to a final decision in a case, then it may be possible that the punitive damages might not be includable in income. See PLR 200107019; but compare the attorney's fee cases discussed below where part of recovery assigned to counsel was still included in plaintiff's income.
3) Damages to compensate plaintiff for defendants' unreasonable delay in litigation are not excludable. Francisco v. U. S., 54 F. Supp 2d 427 (E.D. Pa. 1999), supplemented by 2000-2 USTC ¶ 50,543 (E.D. Pa. 2000). But see PLR 200013005.
(iii) No Double Dip. If a medical expense deduction was taken earlier, an otherwise excludable amount for medical expenses will not be excluded in order to avoid a double tax benefit. IRC § 104(a) (first phrase).
(iv) Related Exclusions. Some other items excludable from income include:
1) workers compensation payments for personal injuries or sickness under IRC § 104(a)(1);
2) certain amounts received through accident, health, or disability insurance under IRC § 104(a)(3) (e.g., where premiums paid by the employee).
3. Attorney's Fees Issues. Legal fees and related costs may be deductible when incurred in connection with employment-related litigation or settlements, if certain requirements are met. Fees paid through contingency arrangements should also be included in income and subject to these same deductibility rules, although there is a current split among the courts on this issue, with some courts excluding such amounts from income.
(a) Deductibility. Fees paid in connection with personal matters are not deductible any more than any other personal expense. However, employment litigation may not be a personal expense in whole or in part, but some or all may fit into a deductible expense category. The most likely grounds for deducting attorney's fees are:
(i) Business Expense. Particularly for the employer, attorney's fees may be reasonable, ordinary, and necessary trade or business expenses. IRC § 162. Generally, these will be deductible unless required to be capitalized under capitalization rules. See William C. Atwater & Co. v. Com'r., 10 TC 218 (1948). For employees, the fees may be deductible under IRC § 162 as being incurred in the trade or business of being an employee. Harvey v. Com'r., 12 TCM 1358 (1953). However, such a deduction by the employee will be subject to the floor on itemized deductions under IRC § 67 and the overall cap on itemized deductions under IRC § 68. See IRC § 62(a)(1). If a tort action not related to the trade or business of being an employee is brought, the fees will not be deductible; for example, libel and slander actions not involving business reputation would not be deductible. See Digser v. Com'r., 26 TC 201 (1956).
(ii) Generation of Income. Also, under IRC § 212, a deduction for attorney's fees may be allowed, even if not a business expense, if the fees are paid or incurred with a reasonable and proximate relation:
1) to the production or collection of income,
2) for the management, conservation, or maintenance of property held for the production of income, or
3) in connection with the determination, collection, or refund of any tax. This includes tax planning. Carpenter v. U. S., 338 F.2d 366 (Ct. Cl. 1964). See Trust of Bingham v. Com'r., 325 U. S. 365 (1945) regarding the proximate relationship test. Deductions under IRC § 212 are also subject to the limitations on itemized deductions.
(iii) Settlements. Fees for preparing for a lawsuit are still deductible where the matter is settled; the origin of the claim test is applied. Alexander v. IRS, 72 F.3d 938 (1st Cir. 1995) (breach of employment agreement settlement).
(iv) Witnesses and Other Costs. Expert witness fees, court fees, transcripts, etc., may be deductible under the standards described above, but contingency fees for witness travel and living expenses during trial might not qualify as "ordinary." Reffett v. Com'r., 39 T.C. 869 (1963).
(b) Excludability of Contingency Fees. Where contingency fees are payable in connection with the bringing of an employment claim, the fees are not excludable from the income of the employee who receives a recovery, a portion of which is retained by counsel; rather, such amounts should be included in income and then deducted under IRC §§ 162 or 212. Com'r. v. Banks, 543 U.S. 426 (U.S. 2005). The fee may not be deductible, however, against the alternative minimum tax under IRC § 56(b) where it is a miscellaneous itemized deduction. This is an application of the assignment of income principle under which the person to whom income is otherwise payable cannot switch the tax responsibility for the income by assigning it to another. Lucas v. Earl, 281 U.S. 111 (1930). This result, however, makes the fee deduction subject to the limitations on itemized deductions and may trigger liability under the alternative minimum tax.
(i) Prior Law. The Courts of Appeal had divided on this issue of excludability. The 7th Circuit, the 3d, 4th, 9th, and Federal Circuits as well as the Tax Court did not allow the excludability of contingency fees. Kenseth v. Com'r., 259 F.3d 881, 88 AFTR 2d ¶ 2001-5378 (7th Cir. 2001), aff'g 114 TC 399 (May 24, 2000) (an attorney's lien under state law is not ownership of the claim and does not change this result; a contingency fee is no more excludable than an hourly fee; the taxpayer's argument that he had insufficient control of the case under the contingency fee arrangement was rejected); O'Brien v. Com'r., 38 T.C. 707 (1962), aff'd 319 F.2d 532 (3d Cir. 1963); Young v. Com'r., 240 F.3d 369 (4th Cir. 2001); Benci-Woodward v. Com'r., 219 F.3d 941 (9th Cir. 2000); Coady v. Com'r., 213 F.3d 1187 (9th Cir. 2000); Baylin v. U. S., 43 F.3d 1451 (Fed. Cir. 1995). On the other hand, the 5th, 6th, and 11th Circuits did allow such exclusion. Cotnam v. Com'r., 263 F.2d 119 (5th Cir. 1959); Srivastava v. Com'r., 220 F.3d 353 (5th Cir. 2000); Estate of Clarks v. U. S., 202 F.3d 854 (6th Cir. 2000); Foster v. U.S., 249 F.3d 1275 (11th Cir. 2001), rev'g 106 F. Supp. 2d 1234 (N.D. Al. 2000).
(ii) Other Consequences. The effect of finding that such attorney's fees are payable to the client may result in the fees being subject to administrative offset or similar consequences relating to other claims against the client. See, e.g., Manning v. Astrue, 510 F.3d 1246 (10th Cir. 2007) (Equal Access to Justice Act fee award in Social Security case subject to administrative offset for student loan claims).
Langdon T. Owen, Jr. is a member of the law firm of Parsons Kinghorn Harris, p.c. in Salt Lake City, Utah. Mr. Owen is a transactional lawyer who practices in the areas of estate and tax planning, business and commercial transactions involving both corporate and partnership taxed enterprises (including tax, employment, and benefit issues relating to such transactions), loans and creditors' workouts, pension and profit sharing plans, health care law, probate, and real estate.