For awards received pursuant to a judgment or settlement for claims involving personal physical injury or sickness, the recipient's tax consequences are determined under section of the Internal Revenue Code IRC. For all other claims i. However, any amount that is attributable to medical expenses that have already been deducted may not be excluded. Congress did not intend the physical symptoms of emotional distress to be considered physical injury or sickness.
When deciding if the exclusion applied, courts looked solely at whether 1 the injury or sickness was personal as opposed to professional 5 and 2 the claim was tort or tort-like as opposed to contractual. It is now clear that damages for discrimination claims are included in income since such claims do not involve physical injury or sickness.
An award may include an explicit amount that represents the recipient's attorneys' fees and other legal costs. This may occur because the court awards the expenses under a fee-shifting statute, the settlement agreement includes the expenses, or there is a contingency fee agreement that grants a specified portion of any award to the attorney.
The amount will be included as compensation in the attorney's income. A plaintiff with a physical personal injury or sickness claim may not deduct the legal expenses incurred in the suit. This is because expenses incurred in the production of tax-exempt income are not deductible. No statutory exclusion exists for payments received pursuant to a judgment or settlement in non-personal injury and non-physical personal injury cases.
The treatment of an award is determined by general tax principles that include the award in the recipient's income unless it is properly designated as a return of capital or there is a statutory exclusion for the item of income that the payment is intended to replace. This is determined by the nature of the underlying claim. For example, an employment suit is a breach of contract claim and any award for back pay is meant to substitute for the payment of wages. Since there is not an exclusion for wages from gross income, the award is included in gross income.
If an award is included in the recipient's gross income, it must be characterized as ordinary income or capital gain. This is important because it determines such things as the appropriate tax rate. The characterization is made by looking at the nature of the underlying claim. For example, if a payment is meant to replace lost profits, then the award is treated as ordinary income.
However, if the payment is to redress an injury to a capital asset, then the amount should be treated as capital gain. Punitive damages that are awarded for a claim of non-personal injury or non-physical personal injury are included in the recipient's income. The amount that may be deducted is the lesser of the compensatory payment less the costs of securing it or the amount of unrecovered net operating loss attributable to the injury.
As mentioned above, an award may include an explicit amount that represents the recipient's attorneys' fees and other legal costs. Prior to a Supreme Court decision in discussed below , 14 it was unclear whether this amount was included in the recipient's income when it was received as part of an award in a non-personal injury or non-physical personal injury case with a contingency fee agreement.
Courts generally required it be included in the recipient's income. However, some courts allowed the amount to be excluded from the recipient's income. In , the Supreme Court resolved the conflict by holding that the recipient is required to include the amount representing attorneys' fees in income.
It began by stating that in situations involving anticipatory assignment of income, like contingency fee agreements, the test for determining if the assignor received the income for tax purpose is if he or she retains control over the income-generating asset. A plaintiff with a claim of non-personal injury or non-physical personal injury may be able to deduct the legal expenses incurred in the suit.
However, if the award was treated as capital gain, then the legal expenses should be capitalized rather than currently deducted. The deductibility of non-business plaintiffs' attorneys' fees will depend on the type of claim.
Under former Section a 2 , back pay received to satisfy such a claim was not excludable from gross income, but damages received for emotional distress are excludable. Notice superseded. Awards and settlements can be divided into two distinct groups to determine whether the payments are taxable or non-taxable.
The first group includes claims relating to physical injuries, and the second group is for claims relating to non-physical injuries. Within these two groups, the claims usually fall into three categories:. Prior to August 21, , IRC Section a 2 did not contain the word "physical" with regard to personal injuries or sickness. The Code was amended SBJPA, PL to exclude from gross income "the amount of any damages other than punitive received whether by suit or agreement and whether as lump sums or as periodic payments on account of personal physical injuries or physical sickness".
The Service has consistently held that compensatory damages, including lost wages, received on account of a personal physical injury are excludable from gross income with the exception of punitive damages. Schleier , U. Damages received for non-physical injury such as emotional distress, defamation and humiliation, although generally includable in gross income, are not subject to Federal employment taxes.
Emotional distress recovery must be on account of attributed to personal physical injuries or sickness unless the amount is for reimbursement of actual medical expenses related to emotional distress that was not previously deducted under IRC Section See Emerson v, Comr. Memo However, the massive budget bill just passed in February of came to the rescue.
It allows an above-the-line deduction of legal fees for whistleblower recoveries under section 21F of the Securities Exchange Act of 15 U. The new law includes the Weinstein tax. The idea is to deny tax deductions for settlement payments in sexual harassment or abuse cases if there is a nondisclosure agreement.
Of course, most legal settlement agreements have some type of confidentiality or nondisclosure provision. And many employment cases have a mixture of facts and claims and a comprehensive settlement agreement. That means lawyers will worry about whether this no-deduction rule will apply. If it applies, it may apply with a vengeance. Even legal fees paid by the plaintiff in a confidential sexual harassment settlement could be covered.
The new provision was added into section , which addresses business expenses. Nevertheless, the language actually enacted into the tax code is much broader. Small allocations to the sexual harassment portion of settlement agreements might be one answer to preserve the availability of deductions for the other claims. For many types of cases involving significant recoveries and attorney fees, the lack of deductions for attorney fees may seem downright confiscatory.
Plaintiffs and their lawyers are unlikely to take the situation lying down. Here are potential ideas for addressing the new rules. Some defendants will agree to pay lawyer and client separately. Do two checks obviate the income to the plaintiff? According to Banks , not hardly. The Form regulations may not help.
However, some taxpayers may still claim reporting positions on these facts. One possible way of deducting legal fees could be a business expense deduction. Businesses did well in the tax bill, and business expense deductions remain unaffected other than the Weinstein provision. But are your activities such that you are really in business, and is the lawsuit related to that business? Alternatively, could your lawsuit itself be viewed as a business? Before the above-the-line deduction for employment claims was enacted in , some plaintiffs argued that their lawsuits amounted to business ventures so they could deduct legal fees.
Plaintiffs usually lost these tax cases. It might be regarded as investment or income-producing activity which used to give rise to a below-the-line deduction , but not a business. And remember, under tax reform, investment expenses — whether legal fees or otherwise — do not qualify for a tax deduction.
However, a plaintiff doing business as a proprietor and regularly filing Schedule C might claim a deduction there for legal fees regarding the trade or business. One other possibility for legal fee deductions is capital recoveries. If your recovery is capital gain, you arguably can capitalize your legal fees and offset them.
You might regard the legal fees as capitalized or as a selling expense to produce the income. But at least you should not have to pay tax on your attorney fees. The Supreme Court laid down the general rule that plaintiffs have gross income on contingent legal fees.
But general rules have exceptions, and the Court alluded to situations in which this percent gross income rule might not apply. Legal fees for injunctive relief may not be income to the client.
The bounds of this exception are unclear, but it may offer a way out on some facts. That seems unlikely. Taxpayers should consider these issues during a litigation or arbitration process. While the federal tax treatment does not depend on whether litigation is concluded by a judgment or order or by agreement of the parties, generally more flexibility exists in clarifying the proper tax characterization of an item when litigation is concluded by settlement rather than judgment, because of a greater ability to clearly reflect the intent of the parties and the purpose for the payment in a settlement agreement.
In general, the proper tax treatment of a recovery or payment from a settlement or judgment is determined by the origin of the claim.
In applying the origin - of - the - claim test, some courts have asked the question "In lieu of what were the damages awarded? For a recipient of a settlement amount, the origin - of - the - claim test determines whether the payment is taxable or nontaxable and, if taxable, whether ordinary or capital gain treatment is appropriate. In general, damages received as a result of a settlement or judgment are taxable to the recipient. However, certain damages may be excludable from income if they represent, for example, gifts or inheritances, payment for personal physical injuries, certain disaster relief payments, amounts for which the taxpayer previously received no tax benefit, cost reimbursements, recovery of capital, or purchase price adjustments.
Damages generally are taxable as ordinary income if the payment relates to a claim for lost profits, but they may be characterized as capital gain to the extent the damages exceed basis if the underlying claim is for damage to a capital asset.
For the payer, the origin - of - the - claim test determines whether the payment is deductible or nondeductible, currently deductible, or required to be capitalized.
For example, a claim for damages arising from a personal transaction may be a nondeductible personal expense. A payment arising from a business activity may be deductible under Sec.
Certain payments are nondeductible as explained further below , and others must be capitalized, such as when the payer obtains an intangible asset or license as a result of a settlement. The burden of proof generally is on the taxpayer to establish the proper tax treatment. Types of evidence that may be considered include legal filings, the terms of the settlement agreement, correspondence between the parties, internal memos, press releases, annual reports, and news publications.
However, as a general rule, the IRS views the initial complaint as most persuasive see Rev. When a payment for a settlement or judgment encompasses more than one claim, a taxpayer must determine how the payment should be allocated.
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