by Jason Freeman
The tax impacts of resolving a dispute (whether settled or adjudicated) is often little more than an afterthought. But a client’s net after-tax recovery can vary drastically depending on the applicable tax rules. An attorney with a keen understanding of the tax principles at play can often help steer a resolution towards the most favorable result for a client.
Basic Tax Principles
Judgments and settlements are, in theory, taxed the same. It is, therefore, generally irrelevant—from a tax perspective, at least—whether a dispute is resolved by a judgment or settlement.
The taxability of a recovery generally turns on the nature of the claim at issue. Under the so-called origin-of-the-claim test, the tax consequences depend upon what, exactly, the amount is truly received “in lieu of.” For example, if the underlying claim sought to recover lost profits, the recovery would be taxable as ordinary income because those profits would have been taxable as such. If, on the other hand, the underlying claim was based on a valid right to inherit as an heir, the recovery may be excludable from income because the inheritance of property is generally not taxable.
A federal authority, including the Internal Revenue Service, will generally look to the pleadings, settlement negotiations, settlement agreement, and the trial court’s orders to determine the true origin and basis of the recovery. As this implies, a party may have some ability to shape the tax consequences of the recovery through its pleadings and theory of recovery, as well as through its documentation of any settlement. Well-thought-out pleadings and theories of damages can sometimes determine taxability.
Both state and federal law play a role in determining federal tax consequences. State law generally determines the nature and extent of a taxpayer’s property interests, while federal law provides the rules governing the taxation of those interests. A settlement agreement that awards or divides property interests in a manner contrary to the underlying state law that governs the claims may trigger unwanted federal tax consequences, such as gift taxation.
The Internal Revenue Code (IRC) and case law specifically address some common types of recoveries. For example, in a commercial litigation setting, claims are often centered on both lost profits and damage to assets. Recoveries for lost profits are taxable. However, recoveries for damage to identifiable assets, including goodwill, are only taxable to the extent they exceed a taxpayer’s tax basis in the assets.
Punitive damages and interest on a recovery are generally taxable, regardless of whether they are awarded in connection with a claim that would otherwise result in a nontaxable recovery.
The IRC excludes from income amounts received “on account of personal physical injuries or physical sickness.” However, neither the IRC nor its regulations define “physical” for these purposes. A frequent issue is whether damages attributable to emotional distress are excludable. While emotional distress is not treated as a physical injury or sickness under the rules, legislative history indicates that a taxpayer may exclude recoveries for emotional distress where that distress manifests from an underlying personal physical injury.
Notably, modern advancements in medical technology may expand the scope of conditions falling under this exclusion. For example, technology may provide evidence of underlying physical changes to the brain associated with conditions (like PTSD or depression) that may have traditionally been viewed as emotional distress.
In the context of trust and estate litigation, property that is acquired by “gift, bequest, devise, or inheritance” is generally excluded from income. Thus, recoveries pursuant to a will contest are generally not subject to income tax where the “origin of the claim” is based upon a right to inherit or take under a will. There are, however, a host of traps for the unwary. For example, payments structured to be paid out of the residuary of an estate may carry out something known as “distributable net income,” which is subject to tax—an often-unintended consequence.
Jason Freeman is the managing member of Freeman Law. He can be reached at email@example.com.