Tax Treatment of Settlement Agreements: A Review For Plaintiffs’ Attorneys

Certain types of tax disputes seem to arise again and again year after year. By way of example, for the past several years the US Tax Court has heard several cases involving injury settlement awards that were not properly structured. The fact patterns in these cases are all basically the same: taxpayer is injured, taxpayer enters into a settlement agreement, taxpayer fails to report the settlement award on their tax return, the IRS issues a notice of deficiency, the taxpayer initiates litigation, and the taxpayer ends up having to pay the tax, penalties, and interest. The rules and issues involved in these cases are relatively simple. This post is just a brief reminder of the rules for the Plaintiffs’ attorneys.

The analysis starts with the rule that all income is taxable income unless the item of income is specifically excepted by some other provision. One such provision provides that any damages (other than punitive damages) are excluded from income if they are received on account of personal physical injuries or physical sickness. Damages for emotional distress do not qualify for this exception. The damages that are allowed include damages received via litigation or settlements if they are based on tort or tort type rights and are received on account of personal physical injuries or sickness. Whether tort rights or tort type rights are involved is based on state law and requires an examination of the nature of the underlying claim. Similarly, whether damages are received on account of personal physical injuries requires an examination of the nature of the claim underlying the settlement.

Simply mentioning a physical injury in the initial pleading is not enough to qualify for this tax exemption. Likewise, simply stating in the settlement agreement that the agreement is for the release of the right to sue, to avoid the expense of trial, or to settle all claims is not sufficient. The settlement agreement must state that the settlement was made solely to compensate the recipient for his or her personal physical injury – even if the settlement is partially for emotional and physical injuries. If the agreement does not contain this language then the IRS will likely issue a notice of deficiency and argue that the intent of making the payment was not to compensate the taxpayer for his or her physical injuries. In these cases the courts almost always find that the intent and dominant reason is simply to settle all claims, rather than to compensate the taxpayer for his or her personal physical injuries.

That is just about all there is to these cases. They are not that difficult and they can easily be avoided; yet they continue to be a problem.