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ke kumu: Should a Payment be Considered as Income or Qualify for a Deduction?

By Trever K. Asam

The conclusion of a litigation matter, whether through judgment or settlement, often brings relief to parties who are eager to move on. But before closing the books, plaintiffs and defendants must consider the tax implications of any payment—including whether the amounts must be taken into income or qualify for a deduction—and ensure that these issues are addressed in any judgment or settlement agreement.

The “origin of the claim” doctrine generally determines the tax treatment of judgments and settlements. Under this doctrine, the origin and nature of the underlying claim is examined to determine its tax treatment. In evaluating claims, the IRS looks to all relevant facts including the allegations underlying the claim, the complaint, evidence presented in the case, and the terms of settlement documents. This approach applies to both the plaintiff and the defendant and further applies whether the amounts are recovered in a judgment or settlement.

As an example, a plaintiff files suit against her employer alleging wrongful discharge and seeking damages of $100,000 in lost wages. The claim is ultimately settled, with the plaintiff receiving $25,000. Because the origin and nature of the underlying claim was for lost wages, the $25,000 recovery is treated as the payment of wages by both sides. The plaintiff must therefore take the entire amount into gross income and must further pay payroll taxes on that amount. The employer may take a business deduction for the $25,000—just like any other payment of wages—and must also pay its share of payroll taxes on the amount.

Special rules govern certain situations. For example, recoveries for physical injury—including physical pain and suffering—are excluded from income by statute and thus are not taxed. Emotional distress, however, does not fall within this exemption. Thus, if the plaintiff in the above example received an additional $10,000 for emotional distress, that amount would still be taxable. The emotional damages recovery, however, would not be characterized as “wages” and would not be subject to payroll taxes. Under other special rules, the receipt of punitive damages is fully taxable, as are many recoveries for attorneys’ fees.

Businesses that recover amounts in litigation must similarly look to the origin of the claim to determine the tax treatment for their recoveries. A recovery for lost profits or revenues, for example, would likely be taxable as ordinary income. A recovery for damages to property, by contrast, may be treated as funds received in exchange for the lost or damaged property. Thus, a recovery of $100,000 for damage to a capital asset might reduce the basis of that asset, but might not be taxable. If, however, the recovery exceeds the asset’s basis, there could be a capital gain. A recovery for lost or damaged inventory is typically treated as ordinary income to the extent that the recovery exceeds cost.

The origin of the claim doctrine applies with equal force to the payor. Thus, settlement amounts paid out by a business may be deductible as “ordinary and necessary business expenses,” but the same deduction might not be available to an individual taxpayer. In some cases, even for businesses, the amounts paid out might not be immediately deductible but would instead be required to be capitalized. As an example, a payment by a project owner to a construction contractor might need to be capitalized into the project (rather than expensed), just like other payments to contractors.

Finally, because the tax treatment for a payment depends on what the payment is for, both parties should give thought to the characterization of these amounts in judgments and settlements. To the extent that judgments are unclear, the parties can work with the court to clarify them and identify any components. Settlement agreements should similarly allocate damage awards between specific claims in the complaint. As an example, the $35,000 employment settlement discussed above might expressly allocate the award between the $25,000 wage recovery and the $10,000 recovery for emotional damages, thus clarifying the tax treatment for both parties on both components. This type of allocation is important because the IRS will expect consistent reporting of the payments by the parties.

The characterization of payments is critical in the context of physical injury awards that may be entirely excludable from the plaintiff’s income. In these situations, plaintiffs have a strong incentive to allocate damages to physical injury whereas defendants may be indifferent. As an example a plaintiff may argue that a recovery in a mixed employment and tort claim should be allocated entirely to physical injury. The employer—who may receive a deduction in either event—may agree to this allocation, but might also require the plaintiff to provide an indemnity if the employer faces any adverse consequences as the result of an IRS challenge.

The tax treatment of a recovery can dramatically alter the economics of a judgment or settlement. Poor planning may expose the parties to unnecessary taxes and prevent the settlement of claims. Tax efficiency, by contrast, can facilitate agreement by stretching damage awards further on both sides. For these reasons—even in the most vigorously contested claims—the desire for good tax planning and appropriate documentation of settlements should be something that both sides can agree on.

This article was published as part of the Spring/Summer 2020 issue of ke kumu, Cades Schutte’s client newsletter. Click here for the full article, which explores some of the laws unique to Hawaii.