I know you have heard someone say, “Ignorance of the law is no excuse!” That may apply in traffic and criminal courts, but it is even worse, or so it seems, in civil court. You know, the place where the neighbor takes you when your dog bites their dog and they want you to pay for the ensuing pet psychiatric bills.
I say this because there are some really good lawyers who seem to be able to get even the worst scoundrel out of jail. Then again, if you slip up and allow somebody in your house to break their leg, it seems no one can get you out of that liability. I’ve even heard of burglars who sued and won!
Given the prevalence of litigation and other legal settlements like worker’s compensation and similar settlements, I thought this might be a good time to go back over income tax rules on litigation settlements.
The first rule you need to know is that, in general, payments received as compensation for personal injury or illness are not taxable. This includes the following type receipts:
- Settlement for damages (other than punitive damages) occurring as a result of a physical injury;
- Amounts received under workmen’s compensation acts as compensation for personal injury or sickness;
- Amounts received through accident or health plans (that have the effect of being accident or health insurance) on account of personal injury or illness if they are reimbursements for medical expenses for which no deduction has previously been taken. If the payments are for other than medical costs and 1) they are paid from contributions made only by your employer or 2) the payments are paid directly by your employer, then the receipts are generally taxable;
- Amounts received as a pension, annuity or similar allowance for personal injury received as a result of service in the armed forces of any country;
- Amounts received as a pension, annuity or similar allowance for personal injury received as a result of service in Coastal or Geodetic Survey or Public Health Service;
- Amounts paid as disability annuity due under section 808 of the Foreign Service Act of 1980;
- Amounts received by an individual as disability income attributable to terrorist or military action.
There are certain eligibility requirements that must be met for individuals to be eligible for the exclusion of disability income for items 4, 5 and 6.
Now that we’ve basically recited the Internal Revenue Code to you, what does all of this mean? Basically, it means that your settlement has to be for actual physical injury or illness for you to exclude it from income. Specifically excluded from the definition of physical injury or illness is “mental pain and suffering.” Also, if the jury decides they wish to award punitive damages to “punish” the defendant, those damages are taxable income.
One of the best examples today of punitive damages that are likely includible in income are the many tobacco settlements. While there is no doubt a portion of those proceeds are for personal injury, it is reasonable to expect a large portion of a $4 billion settlement to one individual will be punitive in nature. With all the budget deficit news these days, you’ve got to wonder if the taxes from these settlements have been factored in.
Similarly, payments that are primarily replacement of compensation are taxable income. For example, assume you work for a company that provides third party sick benefits or pays for all of your short-term and long-term disability insurance. If you are injured or sick and you receive third party benefits paid for by your employer, the income is taxable.
Age and sex discrimination settlements where no physical injury is alleged will result in taxable income. Why are they taxable? It’s because these payments are primarily intended to compensate the victims for lost earnings and to punish the offending employer.
So, what’s your best bet if you are involved in litigation that includes physical injury or illness? Honesty is always the best policy. Well…aggressive honesty is also acceptable. If the settlement is likely to include a personal injury component and a punitive or other component, have your attorney do his level best to include as much as is reasonable
in the personal injury category. Case law is filled with examples where the plaintiff insisted on calling everything “personal injury” only to find out on audit that the law doesn’t really care what the settlement says. What the IRS is concerned with is the economic reality. If the case was really a discrimination case or lost wages case, it’s unlikely that calling the damages “personal injury” damages will fly with the Tax Court.
What are the consequences if you just aren’t able to prove damages related to personal injury? Let’s have some fun and see what a $4 billion punitive award would yield our smoker friend. First, we will assume he gets his cash all at one time and the attorney gets a 40% contingent fee to cover all fees and expenses. Since the numbers are mind-boggling, we will round in our example. After our smoker pays the attorney $1.6 billion, he is left with $2.4 billion. Of this $2.4 billion, $1.120 billion will go to pay Federal taxes and, assuming the case is in California, $280 million will go to pay state income taxes. The attorney will pay approximately $761 million in combined Federal, State and Self-employment taxes.
Assuming our very rough example is close, the net cash available to the plaintiff and attorney from a $4 billion settlement is $1.839 billion or only 46%. Our attorney friend makes out better by keeping 52.5% of his income while the poor smoker gets to keep only 42% of the net $2.4 billion settlement. Had the settlement been all on account of personal injury, the entire $2.4 billion net settlement to the plaintiff would have been tax-free. The attorney would, of course, have paid the same amount of tax. The great inequity in the situation is that the plaintiff must recognize 100% of the settlement as gross income while the attorney fees are deductible only as miscellaneous itemized deductions, which are subject to certain limitations. Don’t worry, this is not necessarily true in all states. If state law gives your attorney a property interest in the settlement, you may be able to just report the net amount you receive as taxable income.
Have you received payments this year on account of personal injury or sickness that you think may be tax-exempt? Are you in the process of negotiating a settlement that could possibly include payments for personal injury or sickness? If either of these is true, give us a call. Let’s discuss the effect on your tax picture if you can negotiate a reasonable settlement for personal injury or if you are concerned about making the right estimated payments. In either case, we have the expertise to help you keep the maximum amount in your pocket.
Have a great October and keep our troops in your hearts and prayers!