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.
The scope of the examination may be limited to the lawsuit proceeds issue. However, the scope should be expanded in cases where other issues need to be addressed using customary examina-tion criteria. Sufficient steps should be taken to thoroughly develop the facts of each case to determine the factual basis of each settlement. Examination Action Plan
Once a constructed file, which includes the necessary IDRS research, is received by the examiner, he or she will contact the taxpayer to set up the initial appointment. The appoint-ment letter to be used will depend on whether the taxpayer has filed a tax return or not. The appointment letter should include a document request including the items shown in Appendix C. NOTE: This step in the examination process can be done by group clerks or management aides. Due to the nature of the issues involved, and the fact that most of the taxpayers involved are wage earners, most of these examinations will probably be held in the office. However, there are instances that would require field visits. For example, the taxpayer has a business that also requires examination.
The most important step of the examination is the development of the facts. The case file should include, at minimum, the original complaint and pleadings, the settlement agreement or release, the disbursement schedule or a clear statement of how the funds were disbursed, and a copy of the agreement relating to the attorney's fee arrangement. These documents are critical in the development of the facts of the case and are vital to Counsel if the case should go to court. In addition, because of the provision in IRC section 7491 concerning the potential for shifting the burden of proof to the government when taxpayers reasonably cooperate with the IRS, examiners should carefully document the level of cooperation taxpayers demonstrated during the audit process.
The next critical step in the examination is to determine the allocation of lawsuit proceeds between punitive and compensatory damages. If the proceeds were received as a result of a litigated case, the amount of punitive and compensatory damages is usually made clear in the court documents, and there may be no further work to be done in making the allocation. However, it is more difficult to make that determination for cases settled out of court. The settlement agreement does not usually make a distinction between the punitive and compensatory damages awarded. These settlement agreements are usually silent as to the types of damages awarded, or they state that all of the damages awarded are "compensatory." Therefore, it is essential that all the facts surrounding the lawsuit be determined and documented. The allocation between compensatory and punitive damages must be made based on the facts of each case. In making this determination, the following items should be considered:
The intent of the payor in making the payment to the plaintiff. Why did the payor settle? For what was the payor paying?
The nature of the claim underlying the plaintiff's award. What was the reason for the suit?
The negotiations between the plaintiff and defendant. Review the case file. Was there a meeting of the minds by the parties?
The actual amount of money it would take to make the plaintiff whole. Did the plaintiff make insurance premium payments or was the plaintiff to receive a certain amount of insurance proceeds? The settlement amount that the plaintiff receives to reimburse him or her for these types of costs are usually compensatory.
If the plaintiff claims to have suffered from mental pain and anguish, determine if the plaintiff received medical treatment for the mental pain and anguish. If so, does he or she have verification of the amount spent for this treatment? Can he or she show that the treatment is directly related to the lawsuit case? In other words, the plaintiff must show that he or she was being made "whole" from the total amount of the settlement received in order for the whole amount of the settlement to be non-taxable. The taxpayer bears the burden at the audit stage of showing that the damages received are excludable from gross income under IRC section 104(a)(2), (although that burden may shift to the government if the issue reaches litigation and the taxpayer satisfies the requirements of IRC section 7491).
Note: The most difficult issue in these cases is the determination of the punitive and compensatory damages when there is a settlement agreement. Normally, it is reasonable for some portion to be allocated to compensatory damages in most cases. Develop the facts carefully and objectively for each case.
- The intent of the payor in making the payment to the plaintiff. Why did the payor settle? For what was the payor paying?
Determine if the taxpayer received any client advances from the attorney. If the taxpayer received advances from the attorney, ensure that the settlement proceeds were not reduced by these advances. Also, determine if the advances were erroneously characterized as legal fees that would provide the taxpayer with a deduction for personal expenses.
Once a determination is made regarding the allocation of the punitive and compensatory damages, the punitive portion of the damages is considered taxable. It is the Service's position that the taxpayer is to be taxed on the full amount of the punitive damages before the attorney is paid any fees. In other words, the taxpayer cannot report the "net" punitive proceeds received. Note: this is an issue that has been litigated continuously.
The taxpayer must include in income the gross amount of the award deemed to be taxable. A deduction is allowed for the legal fees and court costs that are related to the taxable portion of the proceeds. The legal fees and court costs are allowed as a miscellaneous itemized deduction subject to the 2-percent AGI limitation on Schedule A. The deductible fees and costs are determined by using the ratio of taxable proceeds to total proceeds and multiplying the total fees and costs by this ratio. The following is an example.
Total lawsuit proceeds received $100,000 Taxable lawsuit proceeds(80% taxable) 80,000 Legal fees and court costs 52,000 COMPUTATION OF DEDUCTIBLE FEES AND COSTS: Total fees and costs $52,000 Taxable Ratio (80,000/100,000) X .80 _________ Deductible fees and costs* $41,600* ________
*subject to 2% AGI limit
Note: When allowing this as a deduction, consideration should also be given to any other itemized deductions to which the taxpayer may be entitled but did not deduct on the original return because their itemized deductions were less than the standard deduction amount.
AMT must be considered because of the allowance of the miscellaneous itemized deduction. AMT usually becomes due when there is a large amount of miscellaneous itemized deduc-tions. Miscellaneous itemized deductions subject to the 2-percent AGI limitation are a tax preference item for alternative minimum tax purposes. The Report Generating Software (RGS) program for producing Revenue Agent reports will automatically compute this tax.
The following issues should also be considered when making the adjustment to income for the lawsuit proceeds:
Earned Income Credit - If the taxpayer claimed the Earned Income Credit on the original filed return, then it may have to be recaptured as a result of the increase in income from the lawsuit.
Social Security Income - If the taxpayer received any type of Social Security income, the taxable portion of this income may be increased due to the increase in income from the lawsuit.
Exemption - The personal and dependent exemptions taken by the taxpayer may be limited or phased out due to the increase in income from the lawsuit. This is an automatic adjustment and will be computed by the RGS program for producing Revenue Agent reports.
Itemized Deductions - Itemized deductions taken by the taxpayer may be limited or phased out due to the increase in income from the lawsuit settlement. This is another automatic adjustment that will be computed by the RGS program for producing Revenue Agent reports.
- Rental Real Estate Losses - Rental Real Estate Losses could be limited due to the increase in modified AGI. If the modified AGI exceeds the threshold, then passive losses will be limited. The RGS program for producing the Revenue Agent reports will not automatically compute the allowable passive losses.
- Earned Income Credit - If the taxpayer claimed the Earned Income Credit on the original filed return, then it may have to be recaptured as a result of the increase in income from the lawsuit.
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