Some time ago the IRS issued a Guide to Examination Techniques for Taxing Lawsuits, Arbitral Awards, and Settlements. As many accountants can attest, there are a variety of tax issues related to any of these issues. Either way, and while the Audit Technique Guide ("Audit Guide") is a bit out of date, it is still worth reading for a quick look at the issues an IRS auditor will focus on when these types are in place Problems have been identified in an IRS audit.
Section 104 (a) (2) of the Code contains the tax treatment rules for amounts received “as a result of personal injury or physical illness”. Generally, if a lawsuit or settlement falls under section 104 (a) (2), the payment is not taxable. However, the Audit Guide warns IRS auditors that Section 104 (a) (2) only applies to individuals as federal courts have concluded that a business entity cannot suffer personal injury as defined in Section 104 (a) (2) .
The introduction of the Audit Guide also discusses the changes to Section 104 (a) (2) made in 1996. Significantly, the amendment clarified that damage from emotional distress or compensation should not be treated as bodily harm or physical illness (i.e., should be taxable) unless those amounts are paid for medical care that is based on emotional Stress is due. To that end, Section 104 (a) (2) of the Congressional Report stated that emotional distress includes physical symptoms such as insomnia, headache, and stomach disorders that can result from emotional distress.
The amendment to Section 104 (a) (2) also clarified that punitive damages under Section 104 (a) (2) cannot be ruled out, regardless of whether it is received in connection with physical or non-physical injuries.
IRS audit problems.
The Audit Guide instructs IRS auditors to consider a variety of issues when reviewing IRS tax audits that address issues of court judgments and settlements. In general, many of the issues noted in the IRS Audit Guide are used to help determine whether the payment was handled properly for federal tax purposes. These problems include:
- Whether a lawsuit, arbitration award, or settlement payment was not reported;
- Whether the payments have been properly split between taxable and non-taxable amounts;
- Whether part of the payment should be treated as punitive damages (e.g. taxable);
- Whether part of the payment should be treated as interest (e.g., ordinary income); and
- Whether the taxpayer has reported the amounts received as gross instead of reporting them after deducting legal and other fees (important because the Federal Tax Act generally does not allow legal fees, which are marked as various individual deductions).
Tax liability of litigation payments.
In general, the federal tax law provides that the term “gross income” should be interpreted broadly. However, since Section 104 (a) (2) excludes certain types of income from the definition of “gross income”, taxpayers will generally need to demonstrate that the payments fit exactly into the exception. If the taxpayer fails to provide evidence, the taxpayer must report the income for federal income tax purposes.
Difference between jury / court judgments and out-of-court settlements.
In general, a taxpayer can receive a payment from either a jury / court judgment or an out-of-court settlement. The distinction is sometimes important for federal income tax purposes.
For example, if a taxpayer's damages were clearly attributed to an identifiable claim in a controversial proceeding with a judge or jury, the IRS will generally not question the nature of the payment due to the impartial and objective nature of the findings.
However, when an out-of-court settlement is reached, taxpayers can try better to characterize the payment in a tax-favorable manner. Accordingly, the Audit Guide instructs IRS auditors to “closely examine ()” such comparisons to determine whether the treatment and assignments are appropriate and reflect the substance of the comparison.
Assault or illness.
The IRS has consistently determined that claims for damages, including loss of wages due to personal injury, are excluded from gross income (with the exception of punitive damages). Rev. Rul. 85-97. Even after changing section 104 (a) (2), the House Committee report states:
If an act originates in bodily harm or physical illness, all resulting damage (other than punitive damages) will be treated as payments received as a result of bodily harm or physical illness, regardless of whether the recipient of the damage is the injured party or not.
In particular, however, emotional damage according to Section 104 (a) (2) cannot be ruled out. For example, the tax court ruled that an unlawful act for various claims, including emotional distress, cannot be ruled out under Section 104 (a) (2), since the recovery was not made due to bodily harm or physical illness. See Emerson v. Comm’r, T.C. Memo. 2003-82. In addition, the tax court ruled that tort recovery for various claims, including emotional distress and defamation, cannot be ruled out because it was not received due to bodily harm or physical illness.
As explained above, claims for punitive damages according to Section 104 (a) (2) cannot be ruled out. Because taxpayers in out-of-court settlements have a natural tendency to characterize settlement payments as not payments for punitive damages, the audit guide warns auditors to carefully review the settlement agreement to determine if a settlement (or any part of it) is in place. should be characterized as punitive damages. According to the IRS, reassignment may be required if any portion of the payment constitutes punitive damage.
There are many instances where product liability claims are made. The Examination Guide warns IRS examiners that "(t) these types of cases typically concern the various items relating to compensatory damage for physical and mental injury (.)". "
Labor lawsuits can come in a variety of contexts, all of which are instructive in how to properly handle payments for federal tax purposes. If the damage received is intended to compensate for economic losses – lost wages, business income and benefits – such payments are not excluded from gross income, unless it is the result of personal injury.
Federal laws provide grounds for discriminatory measures. These claims can include discrimination based on age, race, gender, religion, or disability. Generally, these cases result in compensation, contract and penalties, none of which are excluded under Section 104 (a) (2).
Defamation and defamation.
In general, defamation and defamation bonuses or settlement payments are intended to compensate the plaintiff for reputational damage. The IRS tends to view these types of premiums or payments – whether business or personal – as non-physical injury and therefore taxable. However, the federal courts disagreed with the IRS's position, especially in the years prior to the amendment to Section 104 (a) (2).
Payroll and self-employment.
Unsurprisingly, a premium or compensation payment can also be a payment that is subject to wage or self-employment tax. In general, this may be the case if the premium or compensation payment would have been primarily subject to these taxes – e.g. B. Paybacks. See e.g. B. Rev. Rul 96-65; Social Security Board v. Nierotko, 327, US 358 (1946) (reimbursement for illegally terminated workers under FLSA, which counts as wages for social security benefit purposes).
With this in mind, the Audit Guide reminds IRS auditors that the definition of “wages” for purposes of payroll and withholding tax is broad. Therefore, it is recommended to IRS auditors that the label on the clearing payments should not regulate whether the payments are subject to payroll and other withholding tax obligations.
Gross income amount.
Generally, plaintiffs prefer to report the net of their recovery as gross income. For example, plaintiffs prefer not to have to show total gross income with deductions for legal fees. At one point, this was because legal fees could be deducted as various individual deductions that are subject to the AMT. At present, however, plaintiffs are generally prohibited from claiming an attorney fee deduction if they are an individual and are attempting to claim any other individual allowance. This is because various individual prints are currently being phased out.
In Comm & # 39; r v. Banks, 543, US 426 (2006), the Supreme Court ruled in favor of the IRS that gross income includes not only recovery, but also the amount of any lawyer fees.
Above the line deduction for legal fees.
In some cases, plaintiffs may claim attorney fees under Section 62 (a) (20) above the line. Generally, these cases are “unlawful discrimination,” certain claims against the federal government, and a private cause of action under the Medicare Secondary Payer Act. The amount of the deduction is limited to the amount included in the gross income of the plaintiffs for the tax year in which the deduction is claimed.
Legal fees for non-taxable premiums and settlements.
No legal fee deduction is permitted for legal fees that are not attributable to taxable premiums or settlements. In the absence of support to the contrary, legal costs related to a taxable and non-taxable premium or settlement payment will be allocated based on the ratio between the taxable premium / settlement and the total premium / settlement. See Johnson-Waters v Comm & # 39; r, T.C. Memo. 1993-333; Church v. Comm & # 39; r, 80 T.C. 1104: 1110 (1983).
In some causes, a plaintiff may be eligible for interest in an arbitration award. Interest associated with a premium or settlement is always taxable. Aames v. Comm’r, 94 T.C. 189 (1990); Kovacs v. Comm’r, 100 T.C. 124 (1993).
IRS Audit Considerations.
In general, the IRS will discover a dispute or settlement either through a Form 1099 issued (by the defendant) or while performing a bank deposit analysis. In these cases, IRS auditors are directed to develop the facts. In most cases, these are interviews with the taxpayer and requests for documents.
Under the guidance of the IRS, the IRS auditors are responsible for reviewing the application of penalties in all cases investigated. If a tax return has not been filed and the taxpayer has received a bonus or compensation payment, the IRS auditor is instructed to review: (1) non-payment of the penalty; (2) failure to pay the fine; (3) estimated tax penalty; and (4) fraudulent failure to file a penalty. In determining whether penalties are appropriate, the IRS auditor is instructed to (1) verify that the taxpayer has fully disclosed all relevant facts to his attorney; (2) advising the lawyer on the tax liability of the settlement amount; and (3) whether the taxpayer should have questioned his attorney's advice on the tax liability of the payment.
Return of information.
In many cases, the defendant will file a return information in the lawsuit. These returns of information can be important in determining the characterization of a settlement payment. In addition, these returns of information are sometimes subject to negotiation between the parties. These information returns can include Forms 1099 and W-2.
Taxing compensation and bonuses is a complex matter. In general, it is advisable to consult a knowledgeable tax advisor during an ongoing legal dispute, and especially prior to entering into a settlement agreement, in order to better position the plaintiff for characterizing the settlement payment or settlement. In cases where a plaintiff hires a tax attorney, the plaintiff can be expected to retain more of their recovery through proper tax planning.
A copy of the IRS Audit Handbook covered in this insight can be found here.