Disclaimer: This article is written as a guide for attorneys. It is not specific legal advise. This article is current only as of October, 2007. Tax Laws Change. If you have questions about the taxation of a settlement agreement, please contact the author, Chris Royer.

Contents

            As a general proposition, yes.  More specifically, it depends on how you allocate the settlement among the various types of damages.  The following table shows the different types of damages and whether they are taxable as income to the client:

                       

Type of Damage	Taxable to the Client as Income?	Who Says?[1]
Lost wages/back pay and front pay	Yes	26 U.S.C. § 104(a)(2); Commissioner v. Schleier, 515 U.S. 323 (1995).
Compensatory damages for emotional distress, pain and suffering (NOT associated with personal physical injury and NOT including medical expenses from emotional distress)	Yes	26 U.S.C. § 104(a)(2)
Compensatory damages for emotional distress, pain, and suffering (associated with personal physical injury)	No	26 U.S.C. § 104(a)(2)
Medical expenses associated with emotional distress	No	26 U.S.C. § 104(a)(2)
Punitive damages EVEN IF ASSOCIATED WITH PHYSICAL INJURY	Yes	26 U.S.C. § 104(a)(2)
Damages arising from a personal physical injury or sickness	No	26 U.S.C. § 104(a)(2)
Liquidated damages (such as FLSA, FMLA, ADEA)	Yes	Commissioner v. Schleier, 515 U.S. 323 (1995) (where liquidated damages are punitive in nature, they are taxable under 26 U.S.C. § 104(a)(2)).
Attorneys’ fees and costs of suit associated with employment discrimination claims	No	26 U.S.C. § 62(a)(20); (e)   (this is the first CRTRA)

 

2.         If all of my client’s settlement is taxable anyway, why should I bother allocating the amounts in the settlement agreement?

            Even though all of the components of a settlement may be taxable, the way they are reported to IRS can vary, depending on the client’s circumstances. The way an amount is reported then determines how taxes must be paid, and in what amount.  Allocation is a good way to minimize, as much as possible, your client’s tax burden.

            Allocating the payments in the settlement agreement may also help your client if, for some reason, the IRS conducts an audit and tries to challenge the way the client has treated the settlement for tax purposes.  If there is no allocation in the agreement, then the IRS is more likely to try to treat all of the settlement as taxable.

When a settlement expressly allocates the settlement proceeds among various types of damages, the allocation is generally binding for tax purposes, as long as the agreement is entered into by the parties in an adversarial context; at arm’s length; and in good faith.[2] 

An express allocation will be disregarded only where the facts and circumstances surrounding the payment indicate that the payment was intended to be for a different purpose.

            If the settlement agreement contains an express allocation of the settlement proceeds, and the allocation is colorable in light of the claims in the Complaint, then it is more likely to be respected and followed.           

3.         So what are the various ways to report these amounts, and what implications does each have?

             Basically, you have two choices:  Form W-2 and Form 1099-MISC.[3]  Within Form 1099-MISC, you have two further choices:  Box 3 or Box 7.  Box 3 is for “other income,” including taxable damage awards.  Box 7 is for “non-employee compensation” over $600.

            Say, for example, you settle your client’s case for $100,000.  Your fee is $40,000.  Of the remaining $60,000, you allocate $20,000 to wage loss and $40,000 to emotional distress. 

            Here’s how you could have each amount reported:

            1.         For the wage loss portion:  choose between W-2 or 1099/Box 7

You really should make this choice with the advice of your client’s accountant or tax advisor.  This decision can depend greatly on the client’s financial circumstances.

a.         If you choose W-2: the Defendant will treat the payment as if it were a payroll check, and will deduct applicable taxes and withholding for Social Security and Medicare (FICA taxes).  The Defendant will also have to remit the matching taxes, which represents 7.65%. 

In this scenario, your client will receive a check for an amount that is less than the $20,000, and will receive a W-2 at the end of the year.

b.         If you choose Form 1099-MISC, Box 7:  the Defendant will cut a check to your client in the full amount of $20,000.  The Defendant will not deduct any state, federal, or FICA taxes from this payment, and it will not remit any matching FICA taxes.  At the end of the year, your client will receive a 1099 with $20,000 reported in Box 7. 

            Under this scenario, it is as if your client had worked for the Defendant as an independent contractor or was self-employed.  This means that your client will be on the hook for all of the taxes.  This includes the employer’s 7.65% match with respect to the FICA taxes, as well as state and federal income taxes, which were not withheld. 

            In general, the downside of this option is that the taxes are not withheld up front, which could impose difficulty for clients who are not in a position to pay taxes (such as folks who count on a tax refund each year).  Another downside is that the client has to pay the employer’s portion of the FICA taxes, as well as the employee portion, so the client may actually end up paying more taxes, even though it appears that she receives more of the $20,000 up front.             

2.         For the emotional-distress damages portion:  The only choice here is to have this portion of the settlement paid via a separate check and reported in Box 3 of Form 1099-MISC.  This box is for “other income” and is specifically designed for taxable damage awards.  In short, you don’t want a situation where your client is paying employment-type taxes on the portion of her settlement that is not wages. 

Be sure to specify in the settlement agreement that this payment is to be reported in Box 3 of the Form 1099-MISC.  If the settlement agreement says only that this payment should be reported on 1099, the Defendant may mistakenly report it in Box 7, resulting in self-employment taxes to your client. 

4.         What if my client is a high wage earner?  Does the analysis change?

            Keep in mind that employees are not on the hook for Social Security taxes on amounts over $98,600.  This means that, if a client earns $100,000 per year, she pays Social Security taxes on the first $98,600 of her salary.  There is no ceiling for Medicare taxes, however, so she pays Medicare taxes on the entire $100,000.

            Say, for example, your client becomes re-employed earning $120,000 a year.  You settle his age-discrimination case with his former employer for $100,000, of which $40,000 is your fee.  Of the remaining $60,000, you allocate $20,000 to wage loss and $40,000 to liquidated damages.

            This may be a situation where it would be better to have the $20,000 reported on Form 1099/Box 7.  This is because none of the $20,000 allocated to wage loss should be subject to Social Security taxes; only Medicare.  The former employer issuing the W-2 may mistakenly deduct Social Security taxes from this amount, resulting in an overpayment.  While the client may get a refund ultimately, he might as well keep the money, not the IRS!

            If the client had received a 1099 instead, he would not pay any FICA taxes associated with Social Security because he is already above the $98,600 threshold for those taxes via his current job.  He would only be responsible for his portion, and the employer’s portion, of the Medicare taxes, which is a relatively small amount.  Keep in mind that the client would still be subject to state and federal income taxes on this amount.  He just gets a break on Social Security taxes.  

5.         What if there is an insurance carrier on the other side? 

            Because your client was not employed by the insurance company, it is not in a position to issue a W-2 to your client for any settlement amounts that you allocate to wage loss and that it ultimately pays out to your client.

            In this situation, if it would be better for your client to have a W-2, you should allocate as little as possible to wage loss.  You could also take advantage of the deductible or retention amount, if it is important for the client to receive a W-2.  In this scenario, if the deductible is $25,000, you could consider allocating that amount to wage loss so that the employer-defendant will make that payment and can then issue the W-2.  You could also consider asking the defendant-employer itself to pay the wage-loss amount of the settlement so that the client may receive a W-2 for it.

             I once was in a situation where an insurance carrier did not want any language in the settlement agreement about reporting the payments, and apparently did not want to report the payments to IRS in any form, 1099 or otherwise.  I found this very odd, but I still incorporated allocations into the agreement.

6.         Now that I’ve figured out how to allocate and report the settlement amounts, how many checks should I have the Defendant cut, and how should my fee be reported?

The IRS recently issued regulations about reporting payments made to attorneys.  The regulations simplify the rules about when a payor (such as a defendant-employer paying a settlement) has to report a payment made to an attorney.  Now, all payments to attorneys must be reported, even where the attorney did not provide legal services to the payor.

What this means for us is that we should think about how settlement checks should be issued:  jointly to ourselves and our clients, or via separate checks to our clients and ourselves.

Consider these examples from the regulations:[4]

A.        One check, made out joint, example where settlement taxable to Client:  Client sues Employer.  Employer and Client settle the case for $300,000.  Settlement is taxable to Client.  Employer writes one check to attorney for $200,000, representing the net amount of the settlement after income and FICA withholding.  Attorney retains $100,000 of the payment as fees, and disburses $100,000 to Client.  Employer must file an information return with respect to Attorney in the amount of $200,000.  Employer must also file an information return with respect to Client in the amount of $300,000.

B.         One check, made out joint, example where settlement not taxable to Client:  Same example as above, but settlement is not taxable to Client because it is for personal physical injuries.  Employer writes check payable jointly to Client and Attorney, and delivers the check to Attorney.  Attorney keeps $120,000 for fees, and disburses $180,000 to Client.  Employer must file an information return with respect to Attorney for $300,000.  Employer does not file any information return with respect to Client because damages are tax-free.

C.        Separate checks, settlement taxable to Client:  Client sues Employer for discrimination; suit is settled for $300,000.  Settlement is taxable to Client.  Attorney has Employer write two checks, one to Attorney for $100,000 as fees, and one to Client in the amount of $200,000.  Employer files an informational report as to Attorney for $100,000.  Employer files an information return with respect to Client for $300,000. 

 

The moral of the story here is that, if you have the Defendant-employer issue one check made out jointly to you and your client, you will receive a 1099 showing the entire amount of the check, even though you disbursed part (most) of it to your client.

If you prefer to receive a 1099 from the Defendant in the actual amount of the attorney fee, then you should have separate checks cut. 

Because Defendants are now sending us 1099s, I keep a filled-out Form W-9 on hand to provide with the signed settlement agreement.  Form W-9 is a request for taxpayer ID number, and you use it to provide the payor with your Social Security Number, or the TIN of your firm. 

7.         I settled my client’s case in June, but then, come January, the employer sent her a 1099 that included the emotional distress amount and the attorney fee.  What happened?

            For example, say you settled your client’s case for $100,000, of which $40,000 is your fee.  $20,000 was allocated to wage loss, and was reported on W-2.  $40,000 was allocated to emotional distress, with no physical injury.  The employer issued a 1099 with $80,000 reported in Box 3. 

            Your client has to report the entire $80,000 as income.  But, she will then receive an “above-the-line” adjustment for the $40,000 that represents the attorney fee.  On Form 1040, line 36 is for “write-in” adjustments.  There is a dotted line on which the client will write in the $40,000 and the letters “UDC.”[5]  The effect of this is that her adjusted gross income (which is figured before standardized deductions are taken) will not include the attorney fee, and she will not pay any taxes on it.  

            Keep in mind that this procedure applies only to attorney fees associated with what the IRS defines as “unlawful discrimination claims.”  The definition of what kinds of cases are covered is contained in 26 U.S.C. § 62(e).[6]  This Code section is actually very broad and covers a wide spectrum of federal claims, and even state claims, including public-policy claims.

            That said, if you have a tort claim, such as defamation or tortious interference with something other than the employment relationship, I believe it would be difficult to characterize those claims as falling under the definitions in § 62(e).  Thus, contingent fees from these types of cases would be taxable as income both to you and to your client.  This is because of the Supreme Court’s decision in Banks.

In Banks v. Commissioner, 543 U.S. 426 (2005), the Supreme Court held that attorneys’ fees are taxable as income to the client, as well as the attorney.  The Supreme Court’s decision reverses the favorable rule in the Sixth Circuit under the lower court decision in Banks, as well as Estate of Clarks ex rel. Brisco-Whittier v. United States, 202 F.3d 854 (6th Cir. 2000).  In these cases, the Sixth Circuit did not require a taxpayer to include the contingent-fee portion of a settlement in his or her gross income. 

8.         Because I went to the NELA conference in Puerto Rico this year, I know that there is another piece of tax legislation in the works to eliminate taxes on emotional distress damages.  What happened to Murphy?  What’s going on??!! 

            The Civil Rights Tax Relief Act of 2007 is in the works and will eliminate taxes on compensatory damages in suits relating to “unlawful discrimination,” and will allow for income averaging for backpay and front pay awards received (don’t ask me about this!).

            According to the text of the H.R. 1540:

Gross income does not include amounts received by a claimant (whether by suit or agreement and whether as lump sums or periodic payment) on account of a claim of unlawful discrimination (as defined by section 62(e)).

            Back pay and front pay awards remain taxable, as do punitive damages, under the new legislation.

            As of this writing, and according to an e-mail from NELA on September 6, 2007, both the House and Senate have pending bills, which have broad bi-partisan sponsorship, and have been referred to committee.  The Senate legislation is S. 1689, and is identical to the House version.

As for Murphy, on July 3, 2007, the D.C. Circuit reversed the decision it previously rendered on August 22, 2006.[7]  This case involved a claim for damages associated with loss of reputation and emotional distress.  Murphy reached a settlement, and paid taxes on the award.  She later sought a refund.   The D.C. Circuit originally held that, although these damages are “income” under Section 104(a)(2), taxing them was unconstitutional under the Sixteenth Amendment.  Although the IRS petitioned for rehearing en banc, the original panel sua sponte vacated its decision and set a new schedule for briefing and oral argument. 

In the July 3rd decision, the Court of Appeals reversed course and held that emotional distress damages are, indeed, income that is subject to tax, where they are not associated with a physical injury.  So we’re back to square one with this issue, and must wait for the passage of the CRTRA.

The bottom line is that, for now, you should treat emotional distress damages associated with non-physical injuries as taxable damages.  Because Murphy is no longer in the picture to change how we deal with compensatory damages, it is not clear when (or if) the CRTRA will be signed into law, or if it will apply retroactively to settlements that occur in 2007.  The current language of the legislation makes it effective for settlements after December 31, 2006. 

I plan to take a “business as usual” approach for now, and treat settlement amounts allocated to emotional distress as taxable damages.  I would advise clients to follow the allocation in the agreement when reporting the income (or not reporting it), and paying taxes.  I would tend to err on the side of over- versus under-payment of taxes. 

9.         How will things change if and when the CRTRA passes?

If/When the CRTRA passes, the way you allocate damages in the settlement agreement will change, as will the way the payments are reported and the way the client pays the taxes.

If the Act passes as written, emotional-distress/compensatory damages will not be taxable income.  Although you will still allocate a portion of the settlement to wage loss and to compensatory damages, you will not allocate any portion of the settlement to punitive damages because those damages remain taxable.  That means that you need to pay careful attention to the language in the settlement agreement describing these damages. 

Right now, settlement agreements that contain broad language including emotional distress, pain, suffering, and “all other damages” Plaintiff is seeking, are fine because all of those damages are taxable.  After the Act passes, that kind of broad, “catch-all” language will not be fine because we should not be lumping punitive damages with compensatory damages.  You could even consider expressly excluding punitive damages from this allocation.

As for the wage-related damages, you will still choose between W-2 and 1099/Box 7 for the reporting mechanism, and the client will still pay taxes on this amount in some fashion.  But you will not allow the Defendant to report the amount allocated to compensatory damages.  The settlement agreement should explicitly state that no 1099 will issue as to this payment.  If the Defendant reports that amount, it may flag the IRS’s attention if your client does not then report it. 

As for the attorney fee portion, the client will still receive a 1099 for the attorney fee portion, and will follow the procedure outlined above for the “above the line” adjustment.

So, for example, you settle your client’s gender discrimination case for $100,000 and your attorney fee is $40,000.  You allocate $20,000 to back wages and have them reported on W-2.  You would then allocate $40,000 expressly to damages for emotional distress, pain and suffering, and humiliation, but excluding punitive damages, and expressly state that this amount will not be reported on Form 1099.  You have the employer cut three separate checks; two to the client and one to you.

Come January, the client will receive a W-2 for the $20,000 in back pay.  The client will also receive a 1099 for the $40,000 attorney fee.  The client should not receive any 1099 relating to the $40,000 payment for the compensatory damages.  The client will report the $40,000 for the attorney fee as income, but will then write in the $40,000 and “UDC” on line 36 of her 1040.  This way, the client is paying taxes only on the $20,000 that was allocated to wage loss.

10.       What about indemnification language in the agreement?  To include or not to include? 

            Many employment practitioners will not permit their clients to indemnify a corporation for tax treatment of settlements.  Many Defendants will insist that your client indemnify it for taxes, penalties, and interest owed, as well as for professional fees associated with dealing with a tax snafu.

My typical practice is to resist indemnification, and compromise with each party acknowledging that it is responsible for its own tax treatment of the settlement amounts paid.  The following are examples of language that I have agreed to:

1.         Basic language, where the other side doesn’t insist on indemnification:  The parties understand and agree that they are each responsible for their own respective tax treatment of the payments made to Client and Client’s counsel under this Agreement, with respect to any taxing authority, whether state, local, or federal.

2.         More extensive language, where indemnification became a potential sticking point:  Here, the Client agrees to indemnify and hold the employer harmless only where he or she has failed to pay taxes owed.  This language expressly excepts any failure on the employer’s part to pay employment taxes.           

Except as otherwise provided in this Paragraph, Client agrees to be solely responsible for and legally bound to make payment of the taxes, if any, which are determined to be owed by Client (including penalties and interest related thereto) by any taxing authority on the payments referred to above.   

Except as otherwise provided in this Release, Client agrees and understands that Employer has not made any representations regarding the tax treatment of the sums paid pursuant to this Release, and Client agrees that she is responsible for determining the tax consequences of such payment and for paying taxes, if any, that may be owed by Client with respect to such payment.   

In the event a claim for such taxes, and/or penalties and interest, is asserted by any taxing authority as a result of Client’s failure to pay any taxes Client has been determined to owe, and except as otherwise provided in this Paragraph, Client agrees to, and hereby indemnifies and holds Employer harmless against any and all tax liability, interest, and/or penalties as may be due as a result of Client’s failure to pay any taxes Client has been determined to owe as a result of the payments referenced above.  Nothing herein shall be construed to render Client responsible for any employment taxes, insurance, or related payments subsequently determined to be the sole responsibility of Employer. 

IF YOU WANT MORE INFORMATION:

            The IRS website (www.irs.gov) is actually a very useful place.  You can get .pdf files of all of the IRS forms, as well as the instructions for the forms.  You can also download .pdf files of various IRS publications (such as Publication 525 on taxable income; there is also one specific to back pay), which can be very helpful to explain how things work.

            I have also found useful information on these issues on big firm websites.  Bookmark sites for the big labor and employment firms (such as Littler, Mendelson at www.littler.com), which often post e-newsletters on “cutting edge” topics in employment law.  Might as well take advantage of them! J

            I also have the number of a very good accountant whom I can call and pester with questions, without annoying him too much or having to pay him.  He is also someone to whom I refer clients if they don’t have their own accountant and want to retain someone to help with these issues.

26 U.S.C. § 62(e):  this is how the Tax Code defines “unlawful discrimination”

(e) Unlawful discrimination defined.--For purposes of subsection (a)(20), the term "unlawful discrimination" means an act that is unlawful under any of the following:

(1) Section 302 of the Civil Rights Act of 1991 ( 2 U.S.C. 1202).

(2) Section 201, 202, 203, 204, 205, 206, or 207 of the Congressional Accountability Act of 1995 (2 U.S.C. 1311, 1321, 1313, 1314, 1315, 1316, or 1317).

(3) The National Labor Relations Act ( 29 U.S.C. 151 et seq.).

(4) The Fair Labor Standards Act of 1938 (29 U.S.C. 201, et seq.).

(5) Section 4 or 15 of the Age Discrimination in Employment Act of 1967 (29 U.S.C. 623 or 633a).

(6) Section 501 or 504 of the Rehabilitation Act of 1973 (29 U.S.C. 791 or 794).

(7) Section 510 of the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1140).

(8) Title IX of the Education Amendments of 1972 (20 U.S.C. 1681 et seq.).

(9) The Employee Polygraph Protection Act of 1988 (29 U.S.C. 2001 et seq.).

(10) The Worker Adjustment and Retraining Notification Act (29 U.S.C. 2102 et seq.).

(11) Section 105 of the Family and Medical Leave Act of 1993 (29 U.S.C. 2615).

(12) Chapter 43 of title 38, United States Code (relating to employment and reemployment rights of members of the uniformed services).

(13) Section 1977, 1979, or 1980 of the Revised Statutes (42 U.S.C. 1981, 1983, or 1985).

(14) Section 703, 704, or 717 of the Civil Rights Act of 1964 (42 U.S.C. 2000e-2, 20003-3, or 2000e-16).

(15) Section 804, 805, 806, 808, or 818 of the Fair Housing Act (42 U.S.C. 3605, 3605, 3606, 3608, or 3617).

(16) Section 102, 202, 302, or 503 of the Americans with Disabilities Act of 1990 (42 U.S.C. 12112, 12132, 12182, or 12203).

(17) Any provision of Federal law (popularly known as whistleblower protection provisions) prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted under Federal law.

(18) Any provision of Federal, State, or local law, or common law claims permitted under Federal, State, or local law--

(i) providing for the enforcement of civil rights, or

(ii) regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.