Brody and Associates LLC

Computing Income Taxes On Legal Settlements

Written by Robert G. Brody and Allison E. Smith on May 17, 2010

As published in the March 22, 2010 Connecticut Law Tribune

IRS still debating when damages may be excluded from income

Taxes can make or break a settlement negotiation. This is especially true in employment cases. The Internal Revenue Service is finally (after approximately 14 years) preparing to issue regulations guiding parties on what part of a legal settlement is taxable and what is not, but the guidance remains murky and changes little.

Public hearings were held last month on proposed modifications to the tax regulations based on amendments to the Internal Revenue Code made in 1996. The key issue from an employment law standpoint is how much of a settlement must be considered wages or is otherwise taxable and how much can be considered non-taxable? Generally, it is all taxable unless the settlement covers (but does not exceed) medical costs incurred or is for physical injury or sickness.

Formalization of this position does little to help parties settle their disputes. Before 1996, Internal Revenue Code §104(a) provided that damages received through prosecution of a legal action or damages received in settlement were excluded from income if received in connection with a physical injury or physical sickness. Furthermore, the alleged claim was required to stem from a “tort or a tort-type” right in order to exclude it from your income. For example, damages due to negligent acts of an employer might have been excludable from income but damages due to a contract breach were not.

Inconsistent Rulings

In 1996, Congress passed the Small Business Job Protection Act, which amended Internal Revenue Code §104(a). Its main thrust was to eliminate the “tort or tort-type” rights test. This expanded the kinds of cases that include tax exempt income, but not significantly. The IRS saw a need for this modification because there were inconsistent rulings from courts regarding the inclusion of certain damage awards as income, including varying rulings on whether punitive damages were excludable from income.

Now all damages received as a result of personal physical injury or physical sickness are excluded from gross income. The amendment also provided that damages for emotional distress must be included in gross income unless the damages are for actual medical costs attributable to the emotional distress. Congress also mandated that punitive damages are taxable income.

Now, 14 years later, the IRS is prepared to revise the regulations to reflect these changes. The revised regulation, §1.1041, would provide that excluded from gross income is “the amount of any damages (other than punitive damages) received … on account of personal physical injuries or physical sickness.” Also, damages for emotional distress “attributable to physical injury or physical sickness are excluded from income….” 

This revised language eliminates the requirement that the injury be defined as a tort or tort-type right under state or common law.

Back Pay

What does this mean for parties settling employment litigation? Most of the money awarded is allocated as back pay, or wages, for the employee. This money is taxable to the employee and must be included by the employer when reporting wages paid, which ultimately means the employer will be charged taxes on these amounts. As a result, employers may pay approximately 15 percent more in taxes for the settlement while employees may receive up to 40 percent less, based on their tax bracket. Thus, when an employer offers $100,000 of back pay in settlement of a discrimination claim, it will cost the employer $115,000 and the employee could net as little as $60,000.

As a result, an employee set on receiving $100,000 could cost the employer almost $200,000. Of course, these amounts could be lowered if part of the settlement was compensation for physical injury or sickness, but medical documentation is needed and that often does not exist in employment litigation.

This revised language eliminates the requirement that the injury be defined as a