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.

Burford v. United States, 642 F. Supp. 635 (N.D. Ala. 1986).

The district court rejected Rev. Rul. 84-108 and concluded that Alabama wrongful death proceeds are excludable from gross income.

O'Gilvie v. United States, (1996 S. Ct.) 519 U.S. 79, 117 S. Ct. 452; 96-2 U.S.T.C. 50,664; 78 AFTR 2d 7454.

The Supreme Court ruled that all non-compensatory punitive damages are taxable.

The Supreme Court ruled that payments received under the federal statute outlawing age discrimination are 100-percent taxable. The ADEA does not provide for recovery of tort-like compensatory damages and the proceeds were not received on account of any personal injury.

Schleier outlined the two-part test that must be met in order to exclude damages under IRC section 104(a)(2): 1) the underlying cause of action giving rise to the recovery must be based on tort or tort-type rights; and 2) the damages must "have been received on account of personal injuries or sickness."

The Supreme Court ruled that back pay received in settlement of claims under Title VII of the Civil Rights Act of 1964, before the 1991 amendments, were not excludable under IRC section 104(a)(2).

The Burke case includes a very good discussion on tort injuries, physical, non-physical, etc.

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The following is a list of other cases that deal with various discrimination claims. All of these are prior to the Supreme Court rulings of Burke and/or Schleier which contain our present authority for these types of cases. While these cases fluctuate on the question of taxability or exclusion (because they are prior to the clear guidance of Burke and Schleier) they contain some good discussions concerning the questions of defining torts and personal injuries, physical and non-physical.

1. Downey v. Commissioner, (1994 7th Cir.) 94-2 U.S.T.C. 50,441; 74 AFTR 2d 6015. In Schleier, the Supreme Court agreed with the discussion relating to torts and the court's holding on the exclusion issue.

2. Johnson-Waters v. Commissioner (1993 Tax Court) 66 T.C.M. 252; T.C. Memo. 1993-333. This case includes good comments about the taxpayer having the burden of proof and "self serving testimony" concerning an out of court settlement allocation. The IRS reallocation to back pay with a small amount for tort-mental distress was upheld. Note, however, the court's holding that the back pay portion recovered under 42 U.S.C. section 1981 is taxable is inconsistent with the rationale underlying Rev. Rul. 93-88.

3. Stocks v. Commissioner, (1992 Tax Court) 98 T.C. 1. This case involves an employment breach of contract and race discrimination issue. No actual lawsuit was filed, but claims were "settled" with an employment termination agreement. The Tax Court looked at the payor's intent in allocating 5/6 of the settlement to the contract and 1/6 of the settlement to the discrimination claim. The evidence showed that the employer was aware of the possibility of the discrimination lawsuit. Their intent was that the payment would settle the potential discrimination lawsuit along with the breach of contract issue. The employer admitted it would not have made the payment unless the taxpayer released them from any discrimination claim as well as the contract claim.

4. Pistillo v. Commissioner, (1989 Tax Court) 57 T.C.M. 874; T.C. Memo.1989-329. The Tax Court found that an ADEA back pay settlement was 100-percent taxable. This decision was later reversed by the 6th Circuit, but contains good comments on several areas of interest including damages and settlements arising from employment contracts, back pay, etc., not excludable under IRC section 104(a)(2). The taxpayer argued that his employer's failure to withhold any federal income tax or social security taxes from the settlement demonstrated its intent to compensate for personal injury. The taxpayer further argued that because the District Court, his attorney, and the IRS stated that the settlement payment was not income, the amount is excludable.

5. Bent v. Commissioner, (1987 3d Cir.) 88-1 U.S.T.C. 9101; 61 AFTR2d 301; 835 F.2d 67. The court ruled that the settlement amount received for violation of the taxpayer's rights to freedom of speech was excludable under IRC section 104(a)(2). If decided after Schleier, taxpayer would fail the second test for exclusion. See Kightlinger v. Commissioner, T.C. Memo. 1998-357, infra.

6. Metzger v. Commissioner (1987 Tax Court) 88 T.C. 834. This was a case involving employment breach of contract and discrimination by sex and national origin. The continued vitality of this case is questionable in light of Burke and Schleier. The Service does not believe that economic damages such as wages can be a measure of a personal injury. Such damages are distinct from personal injury damages.

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The following cases are Employment related and most deal with allocation issues and questions of taxable versus excludable.

1. Barnes v. Commissioner, (1997) T.C. Memo. 1997-25.

   This case involved an out-of-court settlement received due to wrongful discharge with mental distress. The Tax Court allocated 50/50 to mental distress and punitive damages because the mental distress manifested as pre-cancerous tumors.

2. Bagley v. Commissioner, (1995) 105 T.C. 396, aff'd, 121 F.3d 393 (8th Cir. 1997).

   This case involved claims for tortious interference with current and future employment, libel, and invasion of privacy. The trial resulted in a jury verdict that was appealed. A settlement agreement was reached prior to the new trial. This settlement agreement allocated the entire award to compensatory. The Tax Court looked to the facts of the case, including the trial determinations and the negotiations for settlement. The Tax Court determined that a portion should be allocated to punitive, even though the payor stated in negotiations that they would not agree to pay punitive damages. The Tax Court determined that both parties considered the clear possibility of punitive damages being recovered. The Tax Court pointed out that the taxpayer's attorney became aware of the potential for taxability of punitive during the negotiations.

3. [Omitted] 

4. Miller v. Commissioner, (1993) 65 T.C.M. 1884; T.C. Memo. 1993-49.

   This was a defamation case against a former employer. There were two separate lawsuits. One involved a jury verdict and the other suit was not tried. A settlement was reached which covered both lawsuits. The settlement agreement did not allocate the proceeds between compensatory and punitive damages.

   The question presented to the Tax Court was one of allocation between compensatory and punitive. The Tax Court ruled that the verdict by the jury was the best indicator of the payor's intent and the best measure of how the settlement should be allocated.

   Miller includes good analyses and case cites pertaining to settlement allocations. It also includes comments concerning the importance of the nature of the claim versus the validity of the claim in determining the allocation.

5. Mitchell v. Commissioner (1990) 60 T.C.M. 1368; T.C. Memo. 1990-617.

   The taxpayer had prepared a settlement document stating that most of the damages were for libel and slander. The Tax Court determined that all damages related to the employment contract. The taxpayer's employer viewed the libel/slander suit as a "nuisance" suit and gave it no weight in determining the settlement payments.

6. McKim v. Commissioner (1980) 40 T.C.M 9; T.C. Memo. 1980-93.

   The taxpayer sued his former employer after being terminated. His first claim was for unpaid sales commissions and other unpaid job related amounts, such as fringe benefits and unreimbursed expenses. He also brought a claim for suffering, emotional distress and for punitive damages. The court allocated the whole settlement to taxable wages. The court looked to testimony from the taxpayer's employer to determine which claim it had intended to settle. The employer stated it did not believe it had any exposure to liability for any claims for personal injury damages and that these claims did not figure into the settlement amount.

   In conclusion, the Tax Court stated that even if it found that the employer had intended to pay some on each of the taxpayer's claims, the allocation to personal injury would have been minimal. The Tax Court totaled up all the amounts requested in each count (taxpayer had assigned monetary amount to each claim) and determined that the percentage of the personal injury amount requested would only be 15 percent.

7. Seay v. Commissioner (1972) 58 T.C. 32.

   This case involved a breach of contract claim. The taxpayer was allowed to exclude a portion of the payment under IRC section 104(a)(2) for personal injuries. The taxpayer had suffered personal embarrassment, mental and physical strain, and injury to health and personal reputation.

   The government argued that the taxpayer had not proven that his claim for personal injuries was valid or that he had actually incurred such injuries. The court gives an in-depth explanation concerning the fact that the taxpayer does not have to prove the validity of the claim. The taxpayer only has to prove that there was a personal injury claim and that the claim was included in the settlement payment. In this case, the taxpayer was able to show that the personal injury claim had been a part of the negotiations for settlement and that the payor intended to make payment in settlement of that claim.

8. Knuckles v. Commissioner (1965) 65-2 U.S.T.C. 9629; 16 AFTR 2d 5515; 349 F.2d 610.

   Tenth Circuit affirmed the Tax Court. The taxpayer was fired from his executive position based on allegations that he mismanaged the company's affairs. The taxpayer originally sued for breach of contract with no mention of personal injuries. During settlement negotiations the taxpayer's attorney suggested the payment be allocated to personal injuries in order to minimize the tax effect. The taxpayer's employer refused to allocate any damages to personal injury and admit to any liability for personal injury. The taxpayer filed a subsequent personal injury suit 9 months later. Both suits were dismissed with the out-of-court settlement. The Service allocated all to breach of contract (taxable). Taxpayer had allocated all to personal injury (non-taxable). The Tax Court upheld the Service's determination and the Appeals Court affirmed. The Appellate Court stated that the most important fact is "intent of payor."

9. Abrahamsen v. United States, 44 Fed. Cl. 260 (1999) appeal pending, No. 99-5136 (Fed. Cir.).

   In this 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, 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.

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1. Church v. Commissioner (1983) 80 T.C. 1104.

   Case includes formula for allocating legal fees between taxable and non-taxable portions of awards and settlement proceeds for purposes of IRC sections 212 and 265.

2. Alexander v. Internal Revenue Service (1995) 96-1 U.S.T.C. 50,011; 72 F.3d 938; (1st Cir.).

   Great case on legal fees issue. Gross versus net, itemized deductions, and AMT comments included. See also Bagley, 121 F.3d 393 (8th Cir. 1997); Baylin, 43 F.3d 1451 (Fed. Cir. 1995); Coady, T.C. Memo. 1998-291, aff'd, 213 F.3d 1187 (9th Cir. 2000); Srivastava, T.C. Memo. 1998-362, rev'd, 86 AFTR2d 2000-5104 (5th Cir. 2000) ; Sinyard, T.C. Memo. 1998-364; and Benci-Woodward, T.C. Memo. 1998-395, aff'd, 86 AFTR2d 2000-5102 (9th Cir. 2000).

1. Lane v. United States (1995) 95-2 U.S.T.C. 50,455, 76 AFTR2d 6085; 902 F. Supp. 1439 (Dist. Ct. Oklahoma).

   This case involves a claim on an auto insurance policy for uninsured motorists. Basically this is a punitive damage issue case. Note, however, that under Oklahoma law, compensatory damages awarded for insurance bad faith do not compensate for any personal injury. Rather, they constitute in large part compensation for the loss of the use of the contract damages, and in lesser part, additional attorney's fees incurred as a result of the insurer's failure to pay the claim in a timely fashion. Thus, under Schleier, they are not excludable from gross income. However, there are some good points in general concerning suits against insurance companies.

2. Est. of Wesson v. United States (1995) 95-1 U.S.T.C. 50,186, 75 AFTR2d 1540; 48 F.3d 894 (5th Cir.).

   Punitive damage issue that involved bad faith against a life insurance company is addressed in this case.

3. Hawkins v. United States (1994) 94-2 U.S.T.C. 50,386, 74 AFTR2d 5363; 30 F.3d 1077 (9th Cir.).

   Punitive damage issue that involved breach of good faith and fair dealing against Allstate Insurance Company is addressed in this case. Contains a description of shifting Service position on taxation of punitive damages.

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1. Brabson v. United States (1996) 96-1 U.S.T.C. 50,038, 77 AFTR2d 572, 73 F.3d 1040 (10th Circuit), rev'g 859 F. Supp. 1360 (D. Colo. 1994).

   This case involves a personal injury claim. The family was injured by a gas leak in their home. The only issue was the question of whether the pre-judgment interest is excludable under IRC section 104. The district court ruled that the interest was not taxable but the Tenth Circuit reversed.

2. Robinson v. Commissioner (1994) 102 T.C. 116 (Tax Court) (affirmed on allocation by 5th Cir.).

   The taxpayer's out of court settlement allocation was set aside for tax purposes because the negotiations were not conducted in an adversarial manner. The taxpayer was given the freedom to allocate as he wanted in order to minimize the tax effect.

3. Eisler v. Commissioner (1973) 59 T.C. 634.

   Eisler is often quoted in litigation cases. This case involved a business deduction issue. The issue was whether taxpayer could deduct the settlement payment and legal fees under IRC section 162 as a business expense or whether they were to be capitalized.

   The court looked to the strength of the parties' various claims as perceived by their counsel in order to allocate a portion to ordinary and capital.

   The case includes comments on doing the best you can with the information you have.

4. LeFleur v. Commissioner, (1997) T.C. Memo. 1997-312.

   LeFleur is an employment related case, but its particular importance lies in the area of reallocation issues. In this case the IRS successfully reallocated $800,000 from nontaxable emotional distress claims to taxable contract/punitive damage claims. (See Chapter 2 for additional information.)

5. Fabry v. Commissioner, 111 T.C. 305 (1998).

   In Fabry, the Tax Court amplified its prior holdings on the taxability of damages received for injury to an individual's business/professional reputation. The court rejected taxpayer's argument that such injury is, as a matter of law, a personal injury for IRC section 104(a)(2) purposes. Instead, the court held, whether injury to one's business or professional reputation constitutes a personal injury is a question of fact to be resolved by consideration of all the facts and circumstances. Because the taxpayer made no claim for personal injury in the underlying product liability action, the court concluded that the portion of the settlement proceeds allocable to taxpayer's claim for injury to his business reputation was not excludable from gross income.

6. Kightlinger v. Commissioner, T.C. Memo. 1998-357.

   In Kightlinger, the court correctly interpreted Schleier and held that loss of a job does not constitute a personal injury. Also, the court concluded, the economic factors were not a measure of personal injury; rather, they were the injury itself that the taxpayer sustained. Further, the Tax Court, in view of all the contrary evidence in the record, rejected the district court's holding that the suit was for personal injuries suffered by the class members.

7. Gregg v. Commissioner, T.C. Memo. 1999-10.

   In Gregg, the court rejected the taxpayers' argument that compensatory damages received for common law fraud and tortious interference with business relationship were excludable from gross income.

8. Hemelt v. United States, 122 F.3d 204 (4th Cir. 1997); Mayberry v. United States, 151 F.3d 855 (8th Cir. 1998); Dotson v. United States, 87 F.3d 682 (5th Cir. 1996); and Gerbec v. United States, 164 F.3d 1015 (6th Cir. 1999).

   A conflict among the circuits exist on whether payments received in settlement of claims arising under ERISA qualify for exclusion under IRC section 104(a)(2). The Government's position is that notwithstanding the subjective belief of the parties that the statute provided for tort relief, the subsequent determination of the Supreme Court that ERISA does not provide tort remedies is controlling for tax purposes. Two circuits (and two dissenters in the other circuits) agreed that taxpayers failed to meet the first requirement for exclusion. Notwithstanding the intercircuit conflict, the Solicitor General disagreed with Service's recommendation that Supreme Court review is warranted. This disagreement is founded on the fact that Congress, in 1996, amended IRC section 104(a)(2) to provide that the exclusion applies to damages received for personal physical injuries only. Because ERISA does not authorize the recovery of such damages, the administrative importance of the income tax issue has diminished.

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see also:

App C: Letter IRS Tax Law: Lawsuit Awards and Settlements, how to report your compensation
IRS-FREE Tax day help with your large settlements and lawsuit verdicts

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