What are Court Settlements?
By definition, a court settlement is an agreement reached by two or more parties to be accepted and approved by a court of law. The agreed upon terms of a settlement are usually incorporated into a written contract that is submitted to the court for approval. Settlement agreements are typically reached following negotiations among the parties and their attorneys. If both sides are represented by attorneys, then discovery between the parties has likely been completed and the parties are at a stalemate, thus making settlement the best opportunity to resolve the case. In most instances , a settlement agreement is reached prior to the final evidentiary hearing.
A settlement agreement differs from a judgment in that a court must review the terms of the agreement with the parties to ensure that the terms are fair and agreement reached is in the best interest of all parties involved. A judgment is a written document issued by the court after finally adjudicating a case following a final evidentiary hearing, bench trial or jury trial. The court may adopt the parties’ settlement agreement as its final judgment if a settlement is reached before the trial date. The court must approve and incorporate the agreement into its judgment after a trial.
Taxability of Settlements Generally
The general rule is that the proceeds from a court settlement are taxable and includible in gross income. Prior cases, regulations and IRS rulings make it clear that the proceeds of a different types of settlements are includible in gross income, including:
Some courts have imperfectly reached the conclusion that settlement amounts which were received as damages for physical sickness or physical injury are not taxable. However, the IRS disagrees with these courts and has taken the position that verdicts (or settlement proceeds) resulting from injuries where there is no showing of physical harm, regardless of how the injuries affect the taxpayer’s life, are includible in gross income.
Although jury verdicts and settlement proceeds arising from employment-related litigation are typically includible in gross income, the following exceptions have been recognized by the IRS:
The IRS also recognizes that settlement proceeds received because of emotional distress that are purportedly related to physical injuries or physical sickness are excludable only to the extent they do not exceed damages for medical expenses actually incurred.
Finally, it is worth noting that the IRS also excludes from income those payments made pursuant to a divorce or separation settlement agreement that are not alimony, maintenance, spousal support or similar payments within the meaning of Code Section 71.
When Settlements May Not be Taxable
Settlements are not taxable in some situations.
Taxpayers do not have to pay federal income tax on certain court settlements. The following discussion describes instances in which settlements are not taxable.
Injuries: Settlement payments that are intended to cover physical injuries or physical sickness are generally not taxable. Physical injuries or physical sickness include damages for:
• Actual medical bills,
• Special diet or exercise,
• Loss of income (including lost bonuses),
• Impairment of future earning capacity, and
• Damage awards that are meant to compensate you for physical injuries or physical sickness.
Examples
You receive a settlement amount of $500,000.00 from an auto accident. This amount is allocated amongst a physical injury and uninsured motorist claim. The amount of the settlement related to your physical injury was $387,500.00. For the tax year in which you received the settlement payment, you do not report this amount on your income tax return. This is because it is not taxable. The portion of your settlement that compensated you for your uninsured motorist claim is $112,500.00. You report this amount on your income tax return as ordinary income.
You receive a settlement amount of $5,000.00 from your employer for wrongful termination. You must include the $5,000.00 settlement as income on your tax return in the year in which you receive it.
Emotional distress: Damages that you receive as a result of emotional distress are generally taxable. This includes damages for emotional distress or mental anguish. These damages are considered non-physical injuries, and as such, are taxable as income by the IRS. Damages that are for medical care for emotional distress are not taxable. This includes amounts intended to compensate you for psychological injuries that result from a physical injury or for emotional distress that is incidental to a physical injury.
Interest: An interest payment that is part of a settlement payment is generally taxable income. If the settlement agreement specifically states that the settlement amount is inclusive of interest, the entire amount is taxable. As a result, you must report the amount of interest on your income tax return in the year that you receive the payment.
What Settlements are Taxable
There are several elements to a settlement agreement that are typically taxable. These include:
Lost wages – compensation for lost wages is almost always taxable.
Punitive damages (sometimes called "exemplary damages") – punitive damages are taxable.
Interest – there is almost always interest flowing into your settlement, either by statute or as part of the negotiations. Interest is taxable.
Some of the elements of a settlement that are typically taxable include:
Lost Wages – as stated above, compensation for lost wages, even for future lost wages, will almost always be taxable as wages.
Damages for Lost Profit (e.g., lost profits of a business) – damages for lost profits are generally taxable.
The above list is not exhaustive, and often what you think is taxable gets a bit murky. The IRS has a list of damages and their general taxability here.
Examples of how different elements of a lawsuit are taxed are provided here.
Special Considerations by State
There are also state-specific rules and complications when it comes to settlement proceeds. For instance, the method of allocation used in an action will often be mirrored at the state level for state tax purposes. Notably, there are some significant differences in how settlements are treated in key jurisdictions, including New York, California, and Pennsylvania.
New York
Concurrent jurisdiction is an issue in labor and employment matters. To help avoid a situation where a plaintiff can pick and choose which jurisdiction offers a better tax outcome, sections 102 and 103 of the New York State tax code ensure that if the claim was first introduced in a federal court, then only the federal courts have concurrent jurisdiction. As such, a New York State court does not have the power to address the taxation of the settlement proceeds. New York also has a "all or nothing" rule for allocating employee compensation between the non-taxable/exempt portion of the settlement and the portion subject to taxation in New York. In a case where there is a claim for wages, interest on wages, and attorneys’ fees in excess of the attorney’s fee cap, a plaintiff cannot place the entirety of the settlement amount into the non-taxable/exempt category. Note, if the payment is for a period of time in which the plaintiff similarly worked in states other than New York, then the all or nothing rule would not apply for those non-New York state wages. While not technically applicable for complex litigation matters, section 631 of the New York tax code may also present an issue for plaintiffs when the damages sought in the law suit make up multiple categories of damages. This is because courts are bound by this code section to divide the settlement among the categories of damages as follows (if the settlement agreement is silent on the allocation question): 1) 2/3 – lost past and future earnings , including sick pay and related fringe benefits, 2) 1/3 – compensatory damages, including punitive damages, for non-physical injury, or other damages for personal injury, 3) punitive damages, 4) damages for physical injury.
California
Generally speaking, California is a state known for its high standard of living, and correspondingly high state-income tax. California does recognize the Internal Revenue Service’s treatment of deficiency judgment income (income resulting from property encumbered by a corporation failing to fulfill its obligations). Since all parties and the IRS must first agree that an underpayment exists to trigger this treatment, California’s approach to this windfall is to deduct the amount of the deficiency judgment from the business loss for the year the judgment occurred.
Pennsylvania
Four Pennsylvania statutes govern when settlement proceeds are or are not taxable in Pennsylvania. The two most important ones for complex litigation practitioners are 68 P.S. section 251, which prohibits taxation of wrongful death and survival action proceeds, and 26 Pa. Code section 103.22, which prohibits taxation of proceeds from lawsuit settlements for "property damage to building and household goods" to the extent the proceeds do not exceed $100,000. This code section does not apply to constitutional claims. Although we’ve given four examples of key jurisdictions, it’s important to note that every state, and even some municipalities, have their own rules. Importantly, when one jurisdiction has concurrent jurisdiction over the matter, it may prevent the courts of another jurisdiction from having authority over the settlement proceeds. Additionally, allocating the settlement proceeds incorrectly could have significant ramifications that may be expensive or avalanche in scope.
Strategies to Manage Tax Consequences
There are strategies that can minimize the tax implications of a court ordered settlement. Below are five general tips to follow:
- Consult with a tax advisor. Courts are ill equipped to advise individuals about the tax implications of a settlement. For example, courts may not explain what type of income is being received as a result of the settlement (alimony or property distribution). District courts don’t explain these issues in their orders. Courts also don’t provide tax advice. Do not rely upon the court as your tax advisor or as legal tax advice, instead consult with your tax advisor and attorney.
- Communicate with your tax advisor before settling your case. It’s important to communicate with your tax advisor before you reach an agreement in your case. If you already have a signed agreement, then your tax advisor may be able to help you model the tax consequences of the settlement. It is very difficult to address the tax impacts of a settlement after it is reached or after the divorce decree is entered.
- Properly report income and expenses. Make sure you have the untaxed income to report to the IRS. Show the expenses that you are allowed to use the untaxed income to pay, such as in the case of alimony.
- Review your expense schedule. If you can deduct divorce related expenses from your income, review your expense schedule with your CPA or tax advisor.
- Consult with your CPA or tax advisor every year. A CPA or tax advisor should review your tax return every year. It’s important for your CPA or tax advisor to have an understanding of your complete financial situation, including all of your tax returns, tax liabilities, assets, debts and agreements. It is a good idea to also provide your CPA or tax advisor with your divorce decree(s) and marriage settlement agreement(s) every year.
Recent Developments and Changes
Various provisions in the Internal Revenue Code have undergone recent changes which may impact the taxability of court settlements and judgments. Most notably, in the Tax Cuts and Jobs Act of 2017 (the "Act"), Congress amended Internal Revenue Code Section 162(f). Pursuant to this amendment, any settlement, payout or award related to an investigation of, or inquiry into, a violation of a law or regulation in connection with an activity that does not meet the ordinary and necessary business expense requirement, under section 162 is no longer tax deductible. This means civil penalties and fines that were previously undeductible under section 162(f) and were previously excluded from income under section 162(f) are now taxable. Further, the Act added section 6050X, requiring information reporting on settlement amounts that are subject to the section 162(f) exclusion and other specified exclusions, including payments to which the exclusion applies under sections 136 and 457(e), and payments to which the exclusion under section 428(d)(2) applies. These changes are intended to not only deny deductions for certain legal settlements and awards, but also to prevent taxpayers from excluding such amounts from income. While there has not yet been much taxpayer pushback regarding the effect of this change as it relates to legal settlements, it is likely that once taxpayers begin to feel the burden of paying taxes on these settlements they will push back, as was seen in the past when similar tax changes were made.
The IRS has also clarified the tax implications of settlements that were paid for sexual harassment or sexual abuse allegations. Guidance regarding this issue was provided by the IRS on December 20, 2017, via Notice 2018-8 and proposed regulations issued on September 14, 2018. The Act introduced a new provision (section 162(q)) which specifically prevents companies from deducting settlement payouts relating to sexual harassment or sexual abuse if a nondisclosure agreement is a condition to the settlement. Therefore, the only way to deduct settlement payments paid for cases involving sexual harassment or sexual abuse may be for those payments to be made pursuant to a court order, due to the allowability of settlements under section 162(a) where payment of a settlement results in "ordinary and necessary" business expenses. With respect to settlements paid for sexual harassment or sexual abuse allegations, the IRS has included some new requirements to section 6050X reporting as well. Prior to this reporting, the categories of the settlement payments reported were not specific enough to determine if those payments would be able to be tax deductible. In response, the IRS has provided guidance that the settlement payment must now be reported as falling into one of three categories: general allegations of sexual harassment, sexual harassment involving a federal, state or local policy or sexual abuse allegations (the latter two categories are the ones for which the nondisclosure deduction under section 162(q) is applicable).
FAQs
Is settlement money taxable?
Generally, money you receive is not taxable to you. However, the IRS may take the position that some or all of your settlement money is taxable as income, and may challenge your position that part or all of the settlement money is non-taxable if you do not agree with its position. Let’s consider how this may happen.
First, there are a few specific circumstances in which the I.R.S. will take the default position that a settlement payment is taxable, but you may argue otherwise. One of these circumstances relates to a "personal physical injury" or "physical sickness." The key concepts are "compensatory" payments and "physical" or "nonphysical" injuries. Compensatory payments are coverspecifically for pain and suffering, as well as compensatory payments for lost wages or future wages. You should note that if a portion of your payment is for a non-physical injury (e.g., emotional distress), that portion may be taxable to you by the IRS.
Another circumstance involves payments for tax-exempt interest or tax-exempt interest payments. In this case, the payments for tax exempt interest are included in income, unlike tax-free interest from state bonds for example. Thus, although you receive tax-exempt interest payments, those payments must be included in your income for tax purposes.
In a practical sense, it is important to remember that if you agree with the reasons why the I.R.S. takes the position you must include the settlement payment in income, and you want to avoid the risk of a costly and time-consuming audit, you are likely best off including that portion of the settlement payment in income and paying taxes on it . Depending on your tax bracket, your aggregate tax liability from the settlement could be 15%-39.6% (including Medicare/Health Tax). So, if you receive an $80,000 settlement, and your tax bracket is 25%, you would expect to pay $20,000 in taxes. But again, if you do not agree with the position taken by the I.R.S, you should consult with your lawyer and your accountant to determine if it makes any practical sense to fight the I.R.S. on that position. If your accountant and lawyer do not agree with the I.R.S., and there is a practical benefit to fighting the I.R.S., you should certainly consider doing so.
Do I need to report a non-taxable settlement?
No. You must only report taxable settlements to the IRS. Non-taxable settlements should not be reported on your tax return.
How should I report a taxable settlement on my tax return?
If you are claiming that a settlement (or a portion of a settlement) is non-taxable, but you have not been successful at being able to convince the IRS of that position, you simply include the entire settlement in your income on your tax return. So, in the hypothetical above, I would pay $20,000 in taxes (approximately). The IRS cannot second-guess you on this question if your lawyer and your accountant tell you that you must include the settlement payment in income. In short, the I.R.S. cannot write its own ticket and include the settlement payment in income because it disagrees with your accountant’s and your lawyer’s position. I know that I would include the entire $80,000 in income if I were in this hypothetical and the IRS challenge does not create a burden.