Lawsuit Awards and Settlements: IRS Tax Law

With tax day fast approaching, Weitz & Luxenberg wants to ensure our clients have all the information they need to understand how to report their large settlements and lawsuit verdicts to the IRS. This information from the Internal Revenue Service does not consitute legal advice. We provide this document for informational purposes only. If you need help with your taxes, contact a tax attorney or an accountant. To file a personal injury lawsuit, click here.

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Questions may arise concerning pursuit of employment taxes on cases involving employment- related issues, and self-employment taxes on cases involving payments to self-employed persons related to their trade or business.

The employment taxes that may apply include the taxes imposed under the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA), and the Collection of Income Tax at Source on Wages (income tax withholding). If the taxpayer is a railroad employer, the Railroad Retirement Tax Act (RRTA) may apply. FICA taxes, FUTA taxes, and income tax withholding are imposed on "wages" as defined in the Internal Revenue Code. "Wages" is broadly defined as "all remuneration for employment," with certain specific exceptions, for FICA and FUTA purposes (IRC sections 3121(a) and 3306(b), respectively) and "all remuneration for services performed by an employee for his employer," again with specific exceptions, for income tax withholding purposes (IRC section 3401(a)).

In determining the status of settlement payments, keep in mind the broad definitions of "wages." See Social Security Board v. Nierotko, 327 U.S. 358 (1946), and Hemelt v. United States, 122 F.3d 204, 209-211 (4th Cir. 1997).

Be aware that the label placed on settlement payments by the plaintiff and the defendant does not necessarily control the employment tax treatment of such payments. Because both parties generally benefit by classifying payments as non-wage payments, the specific portion of a settlement agreement allocating payments to non-wage payments is generally not based on an arm's length negotiation between adverse parties.

An allocation of the settlement that is reasonable and based on the facts and circumstances of the case should generally be accepted by the Service. A statement by the employer that the settlement payment was made merely to settle the case is of little value in determining whether the payment is wages for employment tax purposes. Generally, if no specific allocation of the settlement is made, the status of the payments would be determined by looking at the claims asserted by the plaintiff and the surrounding facts and circumstances, including the basis upon which the settlement proceeds were distributed. There has been a considerable amount of litigation in connection with the employment taxation of settlement payments, therefore, before relying on any particular case, care should be taken to verify that the case accurately reflects Service position.

There is general agreement that to the extent damages are excludable from gross income, they are not subject to employment taxes. Also, there is general agreement among courts that to the extent a settlement payment made by an employer or former employer represents back pay for services by an employee for the employer, such payments are wages for employment tax purposes. Rev. Rul. 96-65, 1996-2 C.B. 6.

Back pay paid to an employee or former employee by an employer in a settlement related to a claim under a workers' right statute or civil rights statute for a period during which no services were performed by the employee is also wages for federal employment tax purposes. Typically, back pay is awarded if an employee is illegally terminated by an employer, and, under those circumstances, the back pay relates to a period when no services for the employer were performed by the employee because of the illegal termination. The position that back pay is wages even though it is attributable to a period during which actual services were not performed is based on the Supreme Court's holding in Social Security Board v. Nierotko, 327 U.S. 358 (1946), in which back pay awarded to an illegally terminated employee under the Fair Labor Standards Act (FLSA) was held to be wages for social security benefit purposes.

Nierotko has been applied in determining that wages for federal employment tax purposes includes back pay paid under a number of different workers' rights and civil rights statutes (for example, the Back Pay Act, the Age Discrimination in Employment Act (ADEA), and Title VII of the Civil Rights Act of 1964, and state and local discrimination statutes). See Tanaka v. Department of Navy, 788 F.2d 1552, 1553 (Fed. Cir. 1986), and Blim v. Western Electric Co., 731 F.2d 1473, 1480 n.2 (10th Cir. 1980). But see Churchill v. Star Enterprises, 3 F. Supp. 2d 622, 624-25 (E.D. Pa. 1998) holding that an employer could not withhold FICA or income taxes from damages awarded for a violation of the Family and Medical Leave Act, 29 U.S.C. section 2601 et seq, because the employee was not performing services for the employer during the period for which the damages were awarded.

Service position is that "front pay", which is pay awarded to the employee for future services (that is, generally service from the date of the settlement going forward) the employee would have performed but for the illegal actions of the employer, is also wages for federal employment tax purposes. Some courts have disagreed with this position. See Dotson v. United States, 87 F.3d 682, 690 (5th Cir. 1996), holding that payments are not wages if not for services already performed. However, Nierotko supports the Service position. In addition, Service position is that settlements including cash payments made to employees by employers in lieu of providing benefits under employer plans (for example, paid in lieu of health insurance or qualified pension plan benefits) are also wages for federal employment tax purposes, because no exception from wages applies.

Back pay and front pay are wages subject to employment taxes in the year paid, and are subject to the tax rates and FICA and FUTA wage bases in effect in the year paid. See Rev. Rul. 89-35, 1989-1 C.B. 280; Hemelt v. United States, 122 F.3d 204, 210 (4th Cir. 1997); and Mazur v. Commissioner, 386 F. Supp. 752 (W.D. N.Y. 1997). The Service does not follow Bowman v. United States, 824 F.2d 528 (6th Cir. 1987), on the timing of FICA taxation of back pay issue.

There has been much litigation in the area of the employment tax status of settlement agreements, and the Service position has not been followed in many cases. For example, the issue of whether certain payments in settlement of a suit for violation of Employee Retirement Income Security Act (ERISA) are subject to income and FICA taxes has been litigated in four circuits. These cases related to a class action brought by former employees of an employer who engaged in a scheme of terminating employees before they qualified for certain pension benefits. Two circuits agreed with the Government's position that the full amount of the settlements were includable in income and

subject to FICA taxes. See Hemelt v. United States, 122 F.3d 204 (4th Cir. 1997), and Mayberry v. United States, 151 F.3d 855 (8th Cir. 1998). However, in Dotson v. United States, 87 F.3d 682 (5th Cir. 1996), the Fifth Circuit Court of Appeals held that only the back pay portion of the settlement was wages for FICA tax purposes. In Gerbec v. United States, 164 F.3d 1015 (6th Cir. 1999), the Court of Appeals for the Sixth Circuit held that only the portions of the settlement representing back pay and the front pay not attributable to personal injury were subject to FICA taxes. In looking at these four cases, please be aware that the income tax result does not reflect the recent amendment to IRC section 104(a)(2) and that the income and FICA tax results in the cases the Government lost do not reflect Mertens v. Hewitt Associates, 508 U.S. 248 (1993), a Supreme Court case which provides that tort damages are not available for ERISA violations.

In addition, the Service's position is that back wages and front pay paid to individuals who are not hired as employees because of violation of workers' rights or civil rights statutes are wages for federal employment tax purposes. See Rev. Rul. 78-176, 1978-1 C.B. 303, which bases its holding on Nierotko. However, the position of this revenue ruling was rejected in Newhouse v. McCormick & Co., 157 F.3d 582 (8th Cir. 1998).

As a general rule, dismissal pay, severance pay, or other payments for involuntary termination of employment are wages for federal employment tax purposes. See Rev. Rul. 90-72, 1990-2 C.B. 211, and Rev. Rul. 73-166, 1973-1 C.B. 411. See also Abrahamsen v. United States, 44 Fed. Cl. 260 (1999), on downsizing payments. In that consolidated case, approximately 2,600 former employees of IBM sought refunds of income and FICA taxes on the basis that payments received under certain resource reduction programs were excludable from gross income as personal injury damages and consequently were not wages. Noting that none of the plaintiffs instituted a claim against IBM before executing releases and receiving the payments, the court doubted that they satisfied the first test for exclusion. Even if they did satisfy that test, the court concluded that the plaintiffs failed to satisfy the second test that the payments were received "on account of personal injuries." On the FICA issue, the court reasoned that because the payments were linked to salary and length of tenure, the payments were consistent with the notion of wages.

There are a number of exceptions to wages that may apply in settlement cases. For example, legally designated interest and attorney fees may be excepted from wages. Rev. Rul. 80-364, 1980-2 C.B. 294. Also, a limited exception exists for certain settlement payments made to settle claims for the cancellation of the remaining period of a contract for a term of years that is terminated prior to the completion of the contract. See Rev. Rul. 55-520, 1955-2 C.B. 393, and Rev. Rul. 58-301, 1958-1 C.B. 23. These two rulings should be applied only when the facts of the case are identical to the rulings, and comparison should be made with Rev. Rul. 74-252, 1974-1 C.B. 287, and Rev. Rul. 75-44, 1975-1 C.B.15, before applying Rev. Rul. 55-520 or Rev. Rul. 58-301 in any particular case.

"Liquidated damages" awarded under a FLSA settlement are not wages for federal employment tax purposes. Rev. Rul. 72-268, 1972-1 C.B. 313. Under the FLSA such liquidated damages cannot exceed the amount of back pay and must be based on a showing of willful intent of the employer. Similar rules apply to "liquidated damages" under the ADEA. Generally, bona fide damages in settlement of tort claims for personal injury that were excludable from gross income under IRC section 104(a)(2) do not constitute wages for federal employment tax purposes. See Hemelt, 122 F.3d at 210.

In the case of a lawsuit settlement paid by an employer to an employee or former employee, caution should be exercised in determining the existence of any employment tax issues.

In contrast to the broad definition of wages for federal employment tax purposes set forth in Nierotko and other cases, many recent cases have adopted narrow interpretations of what constitutes "self-employment income" for self-employment tax purposes. See IRC section 1402(a) and (b). Under the test adopted by many courts, to be included in self-employment income for self-employment tax purposes, "any income must arise from some actual (whether present, past, or future) income-producing activity of the taxpayer." See Newberry v. Commissioner, 76 T.C. 441 (1981), in which business interruption insurance payments paid to a self-employed individual during the period his store was shut down because of a fire were held not to be self-employment income, and Jackson v. Commissioner, 108 T.C. 130, in which certain termination payments made to a retiring insurance agent were held not to be includable in self-employment income. See, however, Rev. Rul. 91-19, 1991-1 C.B. 186, in which the Service sets forth a slightly different test for inclusion in self-employment income.

Thus, before classifying settlement payments as subject to self-employment tax, care should be taken in determining that the payments can be attributed to the carrying on of a trade or business by the self-employed person.

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In cases involving contingent fee arrangements, the gross award/settlement, without diminution for attorneys' fees or costs, should be included in the taxpayer's income. This treatment is in accord with IRC section 61 and the long established principle, "the fruit of the tree" theory, that income is taxable to the person who earns it and it cannot be assigned to someone else.

Taxing the gross amount from lawsuit proceeds has been upheld in Tax Court, as well as various circuit jurisdictions. See Gadlow, 50 T.C. 975, (1968)(Pennsylvania); Baylin, 43 F.3d 1451, 94-1 U.S.T.C. 50,029 (Fed. Cir. 1993)(Maryland); Alexander, 72 F.3d 938, 96-1 U.S.T.C. 50,011 (1st Cir. 1995), aff'g T.C. Memo. 1995-51(Massachusetts); Coady, T.C. Memo. 1998-291 aff'd, 231 F3d 1187 (9th Cir. 2000)(Alaska); Srivastava, T.C. Memo. 1998-362, rev'd, 86 AFTR2d 2000-5104 (Texas); Sinyard, T.C. Memo. 1998-364(Arizona); and Benci-Woodward, T.C. Memo. 1998-395, aff'd, 86 AFTR2d 2000-5102 (9th Cir. 2000) (California); Kenseth, 114 T.C. No. 26 (May 24, 2000). In Kenseth, the Tax Court held that the anticipatory assignment principles require a taxpayer to include in gross income the entire amount of judgment/settlement proceeds, undiminished by any contingent fee and regardless of the state where a fee agreement is signed. The Tax Court expressly rejected the principles enunciated in cases holding to the contrary.

Examiners handling cases involving payments of attorneys' fees in lawsuits in Alabama, Michigan, and Texas, however, should be aware that there is contrary authority based on an interpretation of applicable state law.

In Cotnam v. Commissioner, 1959, 263 F.2d 119, 59-1 U.S.T.C. 9200, rev'g on this issue, 28 T.C. 947 (1957), the Fifth Circuit, one judge dissenting, determined that attorneys' fees paid directly to the attorney from the judgment under a contingency fee arrangement were not includable in the taxpayer's gross income. The majority of the court reasoned that under Alabama law, attorneys had the same rights as their clients and that Mrs. Cotnam could never have received the portion paid as attorneys' fees. This is a case from the Fifth Circuit, prior to the time a portion of the circuit was split off to form the Eleventh Circuit.

An Action on Decision in the Cotnam case states that the Service will not follow the court's ruling in future cases. The Government has requested the full Court of Appeals for the Eleventh Circuit to reconsider the Cotnam decision. In Davis v. Commissioner, T.C. Memo. 1998-248, aff'd, 210 F.3d 1346 (11th Cir. 2000), the Tax Court concluded it was bound by Cotnam in cases arising under Alabama law, and, thus, ruled adversely to the Commissioner. However, the Eleventh Circuit declined to reconsider Cotnam in the Davis appeal. Similarly, the Fifth Circuit followed Cotnam in reversing the Tax Court's decision in Srivastava. The panel agreed with the Tax Court's rationale in Kenseth but nevertheless, the majority of the panel elected to follow its precedent in Cotnam. The Service is considering whether to recommend to the Department of Justice that Supreme Court review is appropriate and warranted.

The Court of Appeals for the Sixth Circuit followed Cotnam in a case arising under the common law of Michigan. Est. of Arthur L. Clarks, 202 F.3d 854 (6th Cir. 2000). Reversing the judgment of the district court, the Sixth Circuit analogized Michigan common law of liens to the Alabama attorney lien statute. Because the Service did not believe that the Sixth Circuit created a direct conflict with opinions arising under other state laws, the Service did not recommend that the Government file a petition for a writ of certiorari.

Until this issue is resolved, the Action on Decision in Cotnam should be followed and taxpayers should not be allowed to net the proceeds of the direct payment of attorneys' fees in all cases arising under any law other than Alabama, Michigan, and Texas. The Service erroneously excluded the attorneys' fees from the taxpayers' income in Francisco v. United States, 85 AFTR 2d 2000-754 (E.D. Pa. 2000). Further, in cases arising under Alabama, Michigan and Texas law, consult with the appropriate local Office of Chief Counsel for the current status of this issue.

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Generally, individuals, as cash basis taxpayers, may deduct attorneys' fees in the year they are paid, assuming the attorneys' fees otherwise qualify as deductible. In the majority of such cases, the attorneys' fees are paid pursuant to a contingent fee arrangement once damages have been recovered. Where the ultimate recovery is excludable from gross income, either in whole or in part, the payment of contingent attorneys' fees allocable to exempt income are not deductible. IRC section 265(a)(1). The question of the timing and deductibility of attorneys' fees paid prior to resolution of the lawsuit on a noncontingent fee basis requires additional analysis that is not practical to provide in this guide. Examiners should consult with the appropriate Office of Chief Counsel for guidance.

Except in rare cases, such as a compensatory recovery of self-employment income, (for example, commissions that are reported on Schedule C) or recovery of capital gain income, legal fees will be a Schedule A miscellaneous itemized deduction, subject to the 2 percent floor and AMT. (This, of course, assumes that the lawsuit proceeds have been taxed at gross in the taxpayer's income.) Nevertheless, the Tax Court recently held adversely to the Commissioner that a self-employed individual could deduct legal fees allocable to the recovery of punitive damages on Schedule C, rather than as a miscellaneous itemized deduction on Schedule A. Guill, 112 T.C. 325 (1999). Consequently, the court held that the punitive damages recovered by the taxpayer were Schedule C income. The Service is considering the correctness of the court's holding and whether an AOD will be prepared.

See: Church v. Commissioner, 80 T.C. 1104, 1110 (1983); and Alexander, 96-1 U.S.T.C., 50,011; and IRC section 212.

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No legal fee deduction will be allowed for legal fees allocable to non-taxable awards or settlements. IRC section 265(a). Absent strong support to the contrary, legal fees relating to an award or settlement that is partially taxable will be allocated based on the ratio between the taxable award/settlement and the total award/settlement.

See Johnson-Waters, T.C. Memo. 1993-333; and Church, 80 T.C. 1104, 1110 (1983).

Any interest associated with an award or settlement is always taxable. Aames, 94 T.C. 189 (1990); Kovacs, 100 T.C. 124 (1993); Brabson v. United States, 96-1 U.S.T.C. 50,038, 74 AFTR 2d 572, 73 F.3d 1040 (10th Cir. 1996). Some states have enacted statutes requiring defendants to pay judgment interest in tort actions. Where the parties settle an appeal of a verdict, the Service has been successful in convincing the courts that a portion of the proceeds should be allocated to such interest. Delaney, 99 F.3d 20 (1st Cir. 1996), aff'g T.C. Memo. 1995-378.

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see also:

Ch.8: Penalties IRS Tax Law: Lawsuit Awards and Settlements, how to report your compensation
IRS-Tax day help with large settlements & lawsuit verdicts: Penalties

Ch.10: Case Synopsis IRS Tax Law: Lawsuit Awards and Settlements, how to report your compensation
IRS- Tax day help with your large settlements & verdicts - Chapter 10

Tax Law IRS Tax Law: Lawsuit Awards and Settlements
IRS Information: Large settlements and lawsuit verdicts