For anyone who has tasted a victory in litigation and eventually receives a cash settlement there is one bitter fact: Your entire damage award is probably taxable, even the one-third portion that went to pay your attorney. To add insult to injury, attorney fees are not a guaranteed offset to your monetary award. How do you know whether your award is taxable or not? How can the settlement be structured so you can deduct attorney fees? IRS Code Section 104 says that damages are not taxable if for personal physical injury or physical sickness. The IRS 2011 Audit Guide based on the Small Business Job Protection Act of 1996 is also informative. But at the end of the day, your settlement agreement is going to determine whether or not the award is taxable. So if your litigation is about to settle for lump sum or long term payout commencing in 2015, please stay tuned to TaxView with Chris Moss CPA to see how your settlement agreement should be structured for maximum tax savings for you and your family.
Our first case, Stadnyk v IRS US Tax Court (2008) involves an damage award concerning a used car sale.. Mr. and Mrs. Stadnyk bought a used car on December 11, 1996 for $1100 which broke down hours after the sale. Stadnyk failed to resolve the issue with Nicholasville Auto, so she stopped payment on her Bank One check. When Nicholasville Auto discovered that their check was no good, they filed a criminal complaint against Stadnyk. On February 23, 1997 a Fayette County Sheriff arrested Mrs. Stadnyk at her home, handcuffed, photographed and sent her to jail where she was undressed, searched, and forced to wear an orange jumpsuit. Stadnyk was eventually indicted for theft by deception in April of 1997 but the charges were subsequently dropped.
Stadnyk sued Nicholasville Auto and Bank One, alleging breach of fiduciary duty of care, fraudulent misrepresentation and malicious prosecution, abuse of process, false imprisonment and outrageous conduct. The parties mediated and settled for $49,000. Stadnyk received Form 1099-MISC from Bank One reporting the payment of the $49,000 settlement for the 2002 tax year. Stadnyk did not report the settlement proceeds on her 2002 tax return. The IRS audited and claimed the entire settlement was taxable. Stadnyk appealed to US Tax Court in Stadnyk v IRS US Tax Court (2008).
Judge Goeke found that under Kentucky law, a tort had been committed against Stadnyk, the first of a two-prong test required for nontaxable treatment of the award. But the second test, whether the injury created by the tort was physical was more problematic. Because the settlement agreement did not address the issue of whether or not there was physical injury the Court had to look at the facts and evidence presented by Stadnyk. Unfortunately, while Stadnyk endured emotional distress, mortification, humiliation, mental anguish, and damage to her reputation, according to her own testimony, she did not incur a “physical injury” requiring immediate or even longer term medical attention. IRS wins, Stadnyk loses.
Our next case, Simpson v IRS US Tax Court (2013), is about a physical injury in the work place damage award: The facts are simple: Simpson a long term employee of Sears Roebuck and was eventually promoted in October 2000 to run a large troubled store in Fairfield, California which required her to work 50-60 hours a week in addition to her 3 hour daily commute. She also had to engage in strenuous physical activity including receiving unpacking and stocking merchandise. She incurred injury to her shoulders, knees and neck, became exhausted, lost weight and considered suicide. Simpson approached Sears’s human resource manager in 2002 and asked for a transfer to another position. However this request was never communicated to anyone within Sears. Simpson was eventually terminated..
Simpson retained attorney David Anton to file an employment discrimination suit on the basis of gender, age, and harassment. Sears settled in 2009 and paid Simpson $12,000 for lost wages, $98,000 for emotional distress and physical disability and $152,000 to Simpson for attorney fees. In the settlement agreement, Anton attributed 10% to 20% of the $98,000 to work related physical illness. Simpson never filed a workers’ comp claim and Sears never submitted the settlement agreement to the California Workers Comp Appeals Board for approval. Simpson reported $152,000 of the settlement and then netted out $152,000 of attorney fees on her 2009 Form 1040 which had been prepared by H&R Block. The IRS audited and claimed the entire settlement was taxable and disallowed all the attorney fees. Simpson appealed to US Tax Court in Simpson v IRS US Tax Court (2013).
Judge Laro looked at State law and the wording of the settlement agreement, applying the facts of the case to guide the Court as to whether the award was taxable or not. The Settlement agreement was not detailed enough to help the Court. However, the Court found both Simpson and Anton to be credible witnesses. They testified that the award was settlement for Simpson’s work-related physical injury and sickness which would have been excluded from taxation under Section 104(a)(1) and regulations 1.104-1(b). But the IRS countered that Simpson failed to submit the award for approval to the California Workers Comp Board as required by California state law. The Court ultimately ruled to give both the IRS and Simpson a partial victory: In a victory for the IRS, the Court decided that only 10% of the settlement payment of $98,000 was not taxable. However in a victory for Simpson, attorney fees of $152,000 were deductible against $152,000 of taxable settlement under Section 62(a)(20). IRS and Simpson both win in a compromise decision.
What does this mean for anyone out there about to settle litigation for damages? First, your settlement agreement must be specific enough to describe exactly why you are receiving your award. Each of you will have a different unique set of facts that should detailed in the settlement agreement, If the Courts cannot use the settlement agreement to understand whether the injury was physical or not, then the Court will look to the facts and circumstances of your law suit as well as interpret State law for further clarification. Second, make sure your litigation attorney conferences with your tax attorney at the time the law suit is filed, during litigation and finally upon settlement of the case so your award if at all possible could be structured tax free with your attorney fees tax deductible. Finally, have your tax attorney include in your tax return a written opinion as to why the award is not subject to taxation. During an IRS audit years later you will be glad you did.
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Chris Moss CPA