Here’s the typical scenario: you or your business has been involved in a long, drawn-out lawsuit. After months, or more likely, years, of litigation the end is near: the parties have agreed to settle their differences.

But is the person who is to get paid in for a surprise come tax time? Maybe.

The general rule is that settlement funds paid to a claimant are taxable income to the claimant (see, e.g., Carter v. Commissioner, 298 F.2d 192, 194 (8th Cir. 1962); Republic Automotive Parts v. Commissioner, 68 T.C. 822, 823-24 (1977)). This includes payments to settle claims relating to:

• Salary, wages, back pay, front pay, severance pay,overtime pay
• Benefits
• Penalties (unless paid to a governmental entity)
• Punitive damages and double or treble damages
• Liquidated damages
• Compensatory damages
• Interest, including prejudgment interest and post-judgment interest
• Loss of enjoyment of life, shame, humiliation, anxiety, worry, loss of self-esteem, injury to reputation and emotional distress (unless accompanied by physical sickness)
• Attorneys’ fees and costs

 

The major exception is physical injury or sickness. Payments for that are not taxable; however the IRS is aware of attempts by parties to categorize income in such cases as related to the injury/sickness in order to avoid tax on payments for other components (such as lost wages). Therefore, care must be taken in structuring a settlement agreement to avoid IRS challenge.

If you are expecting a settlement, we will be happy to discuss possible tax ramifications with you. Please call our office at (818) 480-3280 to schedule an appointment.