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.
Chapter 8, Penalties
Examiners are responsible for considering the application of penalties in all cases under examination. Many lawsuit settlement cases involve taxpayers who normally do not have to file returns except for the settlement proceeds received. However, returns are still not filed in some situations because the taxpayers and their representatives concluded the proceeds are not taxable. For returns that are not filed, the following penalties should be considered:
- Failure to file penalty (IRC section 6651(a)(1))
- Estimated tax penalty (For Individuals: IRC section 6654)
- Fraud or negligence (Pre-1989 only: IRC section 6653)
- Fraudulent failure to file (Post 1988: IRC section 6651(f))
The accuracy-related penalty applies only where a return is filed and is not applicable to substitutes for returns filed under authority of IRC section 6020(b). These provisions apply to all returns due to be filed after December 31, 1989, without regard to extensions filed.
There is no reasonable cause exception to the IRC section 6654 penalty for underpayment of estimated tax by an individual. The penalties apply unless the taxpayer meets certain specified statutory exceptions. However, in the case of an individual, IRC section 6654(e)(3) provides that the Service may waive the penalty if the Service determines it would be inequitable, due to casualty, disaster, or other unusual circumstances. The Service may also waive the penalty if the taxpayer has retired or become disabled during the taxable year and his or her underpayment was due to reasonable cause and not to willful neglect.
The failure to pay penalty applies to original and amended returns filed by the taxpayer. With regard to returns due prior to June 30, 1996, the failure to pay penalty does not apply when the taxpayer does not file a return or if the return is filed under IRC section 6020(b) substitute for return procedures. With regard to returns due after June 30, 1996, the Service may impose the failure to pay penalties where the taxpayer fails to file a return and a substitute return is prepared by the Service under IRC section 6020(b). IRC section 6651(g).
Lawsuit settlement cases usually result in significant adjustments to income. As in other cases where there are large amounts of unreported income, the accuracy-related penalty and fraud penalties must be considered. Factors to consider in determining whether penalties are warranted include:
- Did the lawsuit settlement recipient adequately disclose all pertinent facts of his or her case to his or her attorney?
- What advice, if any, did his or her attorney provide regarding the taxability of the settlement amount? and
- Should the taxpayer have questioned the advice of his or her attorney regarding the taxability of the payment?
All the facts and circumstances in each case should be considered before making a determination regarding penalties. If the taxpayer received interest income from the settlement and did not report it, more consideration should be given to assessing the accuracy-related penalty on the interest income issue.
If penalties are recommended, the examiner's workpapers should contain comments regarding the examiner's reasons for asserting penalties. If reasonable cause was available and considered, the examiner's workpapers should explain why it was or was not established.