Lawsuit Settlement

Client received a cash settlement. She wouldn't explain details due to agreement not to speak about the case after settlement, but she said it has nothing to do with wages or physical damages. I told her it would help to know the background in order to make the correct decision on whether it is taxable or not. Right now I am going with her term "emotional distress". I think it may pertain to some type of personal injury (like reputation got damaged in some way).

The award was only $19K. She received $15K after lawyer fees. After researching, I believe the amount is taxable. I am just not sure if the whole $19K is taxable or just the $15K. I thought the total would be taxable and the lawyer's fees would not be deductible anymore due to the new tax rules. The check went to the lawyer and he sent her the $15K. I think she should receive a 1099M for the correct amount, but how would that work if the check for the total amount was originally made out and sent to the lawyer. If the check was made out to the lawyer, and he then gives her the $15K, would she receive a 1099M from the lawyer for the total or what she received?

I would appreciate any help anyone has regarding how this would work.

Ruth - I've only been involved in a couple of settlements where there were confidentiality agreements, and those agreements carved out exceptions for information provided to others to file taxes and obtain legal advice. If she won't tell you what is going on - and perhaps you also should insist on reading the settlement documents - then don't do the return. How can you determine the proper tax treatment if you don't know the underlying facts?

All that said...general rule is that the $19k is taxable.

Ruth - I've only been involved in a couple of settlements where there were confidentiality agreements, and those agreements carved out exceptions for information provided to others to file taxes and obtain legal advice. If she won't tell you what is going on - and perhaps you also should insist on reading the settlement documents - then don't do the return. How can you determine the proper tax treatment if you don't know the underlying facts?

All that said...general rule is that the $19k is taxable.

I have also run across this situation from time to time. The lawyers who draft these kinds of agreements -- without making an express exception for disclosures reasonably appropriate to comply with the U.S. internal revenue laws -- arguably are not thinking things through.

In order to protect oneself against the imposition of certain kinds of penalties under the Internal Revenue Code, a taxpayer might need to disclose specific details of the reason for a particular recovery (regardless of whether the taxpayer contends that the recovery is includible in gross income or not). Same situation for the taxpayer claiming a deduction in connection with the transaction. The taxpayer also needs to make the disclosure to the tax return preparer.

Here's another situation. If for some reason the IRS were to issue an administrative summons for information covered by such a confidentiality agreement, the taxpayer would generally have no legal defense to prevent compelled disclosure to the IRS. A contract between two private parties does not override the Internal Revenue Code. A taxpayer might argue -- successfully -- that the confidentiality agreement is fully or partially void or voidable, under ordinary principles of contract law, to the extent that the agreement purports to limit the right of the taxpayer to make disclosures to the tax return preparer and the IRS.

Yes, I agree with the above. I did tell her that I felt she needs to at least give me an overview of what it is about without disclosing names, places, etc. She is just paranoid about it. She would like to disclose the info (seeing I am a friend of hers and have been doing her taxes for 30 years). She is going to ask her lawyer. But going on the facts I listed, I would like to know if the total, or amount given to her after fees is what I would tax her on. Also, would it be entered as "Other Income" on form 1040?

Settlements that are purely for emotional distress are fully taxable, including the amount received for legal fees. If the lawsuit involved one of the types of claims described in section 62(a)(20), such as unlawful discrimination, then the legal fees may be deducted “above the line.”

So, start with the position that the entire $19k is taxable and go from there. If the amount received is back wages or back compensation for services, then report it as wages or compensation income. If not, report it as other income.

Thanks so much Dave. That is what I needed to know, especially if they are for wages and not distress as she mentioned. I may be speaking with the lawyer to make sure I get the right info. Thanks everyone for the responses.

One more comment, Ruth. Since the taxability of the settlement is usually dependent on the "origin of the claim" theory, you might be able to get all of the information you need from the complaint filed by your client's attorney, since it will describe all of the allegations and list the causes of action. You might not need to see the settlement agreement.

One more comment, Ruth. Since the taxability of the settlement is usually dependent on the "origin of the claim" theory, you might be able to get all of the information you need from the complaint filed by your client's attorney, since it will describe all of the allegations and list the causes of action. You might not need to see the settlement agreement.

Dave hit the nail on the head. The document that started the case (the "complaint" if it was Federal court, or sometimes the "petition" in some state courts) is often much more helpful than the final settlement document.

I finally got some info from the lawyer. Below is the info he gave me. After reading the below my mind is changing from taxable to non-taxable.

The client had a claim for negligence by the PD in taking her into so-called protective custody (getting drunk on News' Year Eve). Her claim was for personal injury.

He wrote "There was no judgment in her case. She had a claim for negligence by the PD in taking her into so-called protective custody. Her claim was for personal injury. He wrote (I saw in Pub 525) that "Damages are taxable when obtained for emotional distress that did not arise from some form of wrongful physical conduct, such as discrimination. Here the client's injuries arose from wrongful physical conduct (locking her up overnight). Her damages are not for emotional distress but for physical and mental pain and suffering. Physical and mental suffering, which under the law is a very different animal than emotional distress. Emotional distress is a mental condition that may be caused by physical injury (such as a car accident or an assault leading to PTSD) or by non-physical conduct like discrimination. The client's successful claim was not for emotional distress, but for physical pain and suffering arising from physical misconduct. To be sure, she was not physically assaulted, but under the law wrongfully confining a person is physical injury per se." He also noted that there was no punitive damages. It was only compensatory.

After reading the above does anyone feel the same as I do, that the award would not be taxable?

The Sixth Circuit disagrees. STADNYK v. COMMISSIONER OF INTERNAL REVENUE (2010)

Petitioners are asking the Court to create a per se rule that every false imprisonment claim necessarily involves a physical injury, even though physical injury is not a required element of false imprisonment under Kentucky law. To be sure, a false imprisonment claim may cause a physical injury, such as an injured wrist as a result of being handcuffed. But the mere fact that false imprisonment involves a physical act—restraining the victim's freedom—does not mean that the victim is necessarily physically injured as a result of that physical act. In the instant case, Mrs. Stadnyk unequivocally testified that she suffered no physical injuries as a result of her physical restraint. Thus, Petitioners have failed to establish that Mrs. Stadnyk suffered from personal physical injuries or physical sickness.

[Emphasis in original]

Thus, Petitioner's settlement award may not be excluded from taxation under § 104(a)(2).

Great info. I'm learning so much everyday! Thanks so much everyone!!

I received the below statement from her lawyer. Does this make sense why he believes it is not taxable?

"There was no judgment or award because the case was settled by agreement without trial. As is customary, the check was payable to both xxxx and my partner, xxxx. It was deposited in our client funds holding account and she received a check for her net recovery from that account. We did not issue a 1099 to her and neither did the city of xxxx. Typically when a suit is settled we receive a 1099 for the entire amount; I find no 1099 for this settlement in our system".

He continued: "I think one confusing issue here is the distinction between a claim for emotional distress resulting from physical injury (proceeds not taxable) versus emotional distress resulting from non-physical misconduct (proceeds taxable). xxxx's arrest and confinement were physical acts that fit the legal definition of assault and battery. (ANY intentional touching of a person without her consent is a battery.) They caused her physical injury and discomfort -- fortunately transient but real nevertheless."

"The other confusing issue, which I hope we've tried to address, is physical and mental pain and suffering versus emotional distress. For various reasons, including potential tax complications, we did not pursue a claim for emotional distress. But even if this recovery were considered to be for emotional distress, it was distress resulting from physical restraint and injury,"

I don't know how the 1099's work for these settlements, but I have always found the 1099's sent to everyone after the year ends. Not being a lawyer, I would like to know if it is customary for payer to send the 1099s before the year ends. I get the impression from his statement that he doesn't expect her or his firm to receive a 1099 because he hasn't received it yet. Do you know if this is customary? I know the check was made out to both of them and listed her social security number. I think she should get a 1099 for the total $19K.

He continued: "I think one confusing issue here is the distinction between a claim for emotional distress resulting from physical injury (proceeds not taxable) versus emotional distress resulting from non-physical misconduct (proceeds taxable). xxxx's arrest and confinement were physical acts that fit the legal definition of assault and battery. (ANY intentional touching of a person without her consent is a battery.) They caused her physical injury and discomfort -- fortunately transient but real nevertheless."

Yeah, right.

Come on.

An offensive touching -- which of course does involve physical contact -- is not the same as a "physical injury or sickness."

Under that lawyer's "reasoning," if a wrongdoer only offensively tapped a victim very lightly on her hand (a battery under common law), a monetary recovery for emotional distress related to the incident would be non-taxable under 104(a)(2) merely because a physical contact of the victim's body was involved.

Section 104(a)(4) excludes, from gross income, a monetary recovery in connection with a physical injury or sickness, not a monetary recovery in connection with an incident merely because the incident involved a physical offensive touching or a wrongful physical confinement. The victim of a wrongful arrest, or the victim of a wrongful physical confinement, might be said to have a cause of action because the victim is considered to have been "injured" in some general way, but that kind of "injury" -- in and of itself -- is not a section 104(a)(2) "physical injury or sickness".

That lawyer is playing with words. And I'm shocked! Shocked! Shocked, I tell you -- to see a lawyer engage in this kind of thing!

LW25 is right. This settlement is taxable, regardless of what the attorney is saying.

Arrest and confinement that fit the legal definition of assault and battery is not a physical injury that renders the settlement excludable under 104(a)(2). The Stadnyk case that MSchmahl linked to in #10 above proves that the attorney is wrong. Here is the entire paragraph that contained MSchmahl's quote:

However, despite Mrs. Stadnyk's testimony, Petitioners argue that Mrs. Stadnyk suffered a physical injury because "[p]hysical restraint and detention and the resulting deprivation of [Mrs. Stadnyk's] personal liberty is [itself] a physical injury . . . that Mrs. Stadnyk endured for an eight hour period." (Pets.' Br. at 15.) Petitioners further argue that Mrs. Stadnyk suffered physical damages in addition to emotional damages because "to be falsely imprisoned, the person must first be physically restrained or held against their will" and "[t]hus the damages received from false imprisonment arise from the person's physical loss of their freedom and the mental suffering and humiliation that accompany this deprivation." (Pets.' Br. at 15.) In other words, Petitioners are asking the Court to create a per se rule that every false imprisonment claim necessarily involves a physical injury, even though physical injury is not a required element of false imprisonment under Kentucky law. To be sure, a false imprisonment claim may cause a physical injury, such as an injured wrist as a result of being handcuffed. But the mere fact that false imprisonment involves a physical act-restraining the victim's freedom-does not mean that the victim is necessarily physically injured as a result of that physical act. In the instant case, Mrs. Stadnyk unequivocally testified that she suffered no physical injuries as a result of her physical restraint. Thus, Petitioners have failed to establish that Mrs. Stadnyk suffered from personal physical injuries or physical sickness.

Stadynk v. Commissioner, 367 Fed. Appx. 586 (6th Cir. 2010).

This clearly shows that what the attorney is arguing won’t hold water. He might be a very good lawyer when it comes to obtaining a settlement for his client, but his knowledge of tax law is lacking.

I have asked the lawyer if I could read the original complaint and the settlement information. If he doesn't allow me to read these, I will disengage. I will give my client and myself the benefit of her going to another preparer with more experience in order to make the correct decision. I will explain everything to her and suggest she make the estimated tax payments to cover herself. This way if the settlement is found to be nontaxable she will get it back with a refund when doing her tax return.

Although it's probably a longshot, you might send a copy of the Stadnyk 6th Circuit opinion to the attorney and your client and see if they change their position.

Settlements that are purely for emotional distress are fully taxable, including the amount received for legal fees. If the lawsuit involved one of the types of claims described in section 62(a)(20), such as unlawful discrimination, then the legal fees may be deducted “above the line.”

So, start with the position that the entire $19k is taxable and go from there. If the amount received is back wages or back compensation for services, then report it as wages or compensation income. If not, report it as other income.

This - and I also agree that the above the line adjustment does not apply imho.


Which doesn't

I have asked the lawyer if I could read the original complaint and the settlement information. If he doesn't allow me to read these, I will disengage. I will give my client and myself the benefit of her going to another preparer with more experience in order to make the correct decision. I will explain everything to her and suggest she make the estimated tax payments to cover herself. This way if the settlement is found to be nontaxable she will get it back with a refund when doing her tax return.

This too (also imho). There situations generally end up with clients asking for marginal positions and take up a ton of your time - and then complain when you charge them for one or two line entries. It doesn't sound like it is worth it for you.

If this guy's award was not considered nontaxable due to physical injury, I don't think your client's would be:
https://www.leagle.com/decision/intco20090428798

I do think you need to see the paperwork to see exactly how things were worded, but my initial thought is that it is taxable.

99% of the time, the settlement agreement has no information. It is one page and tells you nothing.

Sounds taxable to me.