Tax Treatment of Settlement Agreements (Again)

The classification of settlement payments for purposes of federal income taxes continues to be a problem for taxpayers and for their legal advisers. The Ninth Circuit, in Rivera v. Baker West, Inc., recently upheld a lower court’s determination that an employer correctly withheld federal taxes from a settlement agreement paid to a former employee.

The Rivera case involved a race discrimination and wrongful termination lawsuit. Rivera’s petition did not include a claim for physical injuries or for emotional distress. The employer and employee entered into a settlement agreement, which was to pay the employee $40,000 “less all lawfully required withholdings.” The agreement did not specify whether the payment was for lost wages or for back pay. The employer issued the employee a check for $25,140, which was $40,000 less state and federal income tax and FICA withholdings. The employee cashed the settlement check and the employer requested that the lower court dismiss the case. The employee argued that the employer should be required to pay the full $40,000 listed in the settlement agreement. The lower court dismissed the case, the employee appealed, and the Ninth Circuit affirmed the lower court’s dismissal.

The law is not what makes these types of cases interesting. The law in this area is well settled. What makes these cases interesting is that the taxpayers are apparently not being advised as to how to structure their cases so that the award or settlement will be fully or partially tax-free. That is what the Rivera case really involved.

There are ample opportunities to structure settlements so that they are wholly or partially non-taxable. For example, taxpayers could include a claim for physical injuries in the initial petition, conduct discovery to build a case for physical injuries, and/or include appropriate language in the settlement agreement specifying that the payment is for physical injuries or sickness. Structuring settlements in this fashion to avoid taxes is common and it is relatively simple. Even the IRS has noted that structuring settlements has resulted in significant losses of tax revenues. In fact, in 2001 the IRS developed and published a lawsuit audit guide (under the Market Segment Specialization Program) to help IRS examiners recognize and manage tax-structured settlement agreements (copy available at http://www.irs.gov/pub/irs-mssp/a9lawsut.pdf). Yet these types of cases continue to crop up.

The frequency of this type of litigation indicates that plaintiffs’ counsel is not taking the time structure cases so that the resulting settlements or awards will be tax -free to the recipients. This situation often puts plaintiffs’ counsel in the position of arguing that the tax treatment should be different — which is pointless after the structuring opportunities have passed — in an effort to head off or mitigate legal malpractice claims. That is what appears to have happened in the Rivera case. To the extent that this type of case can be avoided, such litigation is unnecessary; a wasteful use of our judicial resources; and that it continues to crop up is surprising given the amount of money, taxes, and malpractice exposure involved.