This is the third in a series of articles on issues surrounding the Taxation of Settlements and Verdicts. This article identifies some of the things you can do to protect the character of the award.

Allocate Damages. If a settlement agreement allocates the settlement payment among items taxable as ordinary income, items taxable as a capital recovery and items excluded from taxation, the allocation is generally binding for tax purposes to the extent that the agreement is entered by the parties in an adversarial context, at arms’ length, and in good faith.

IRS and Court May Ignore an Unsupported Allocation. Neither the IRS nor the Courts are required to accept the parties’ allocation and may reallocate the payment to claims they believe are more consistent with the facts. The IRS and the Courts will look to the following information to determine the proper allocation:

Trial Court Judgment;
Trial Exhibits;
Settlement Agreement;
Drafts of the Settlement Agreement;
Correspondence between counsel, including demand letters, and settlement negotiations;
Communications with third parties including accountants;
Witness affidavits/statements;
Deposition transcripts;
Original and Amended Complaints;
Discovery;
Medical Reports;
Medical Expense Payments.

Risk of No Allocation. Where plaintiff’s complaint includes multiple theories of damages, but the settlement agreement contains no allocation of the award among the various theories, the IRS will take the position that damages, for which the taxpayer was likely to receive an award had the case gone to trial, must be allocated among the types of damages claimed. Rev. Rul. 85-98, 1985-2 C.B. 51. The IRS and the Court will look to, among other things, the pleadings, evidence, and arguments made by the taxpayer in the Court proceedings.

Post-Judgment Settlements. For cases settled after the judgment, the IRS will expect a pro rata allocation of the settlement consistent with the judgment. For example,

A trial Court awarded a taxpayer $300,000 in nontaxable compensatory damages and $100,000 in taxable damages. The defendant appealed the decision, but the parties settled the case for $200,000 before the appeal was heard. The settlement agreement did not allocate the settlement amount between nontaxable and taxable damages. Because 25 percent of the trial Court’s total award was in the form of taxable damages ($100,000/$400,000), the IRS will likely allocate 25 percent of the settlement amount to taxable damages for tax purposes. Thus, the taxpayer must include $50,000 ($200,000 x .25) in gross income, but he may exclude the remaining $150,000 as damages received on account of physical personal injuries.The parties still have the ability to allocate the damages after judgment based on the strength of each claim being appealed. The plaintiff may give up the taxable claim on the basis that his chances in Appeals are weak in exchange for immediate payment of the nontaxable claim, which is the strongest part of the case. The allocation must be based in fact and well documented.

This is the second in a series of articles on issues surrounding the Taxation of Settlements and Verdicts. This article addresses the amounts that can be excluded from gross income.

Amounts Excluded. Internal Revenue Code Section 104(a)(2) excludes from gross income compensatory damages:

1. Received through prosecution of a legal suit or action or through a settlement agreement entered into in lieu of such prosecution,2. Based on tort or tort-type rights, and 3. Paid on account of physical personal injuries or sickness.Amounts Not Excluded. IRC Section 104 does not apply to punitive damages, except as allowed by Section 104 (c), amounts received as reimbursements for medical expenses previously deducted under Code Section 213, Rev. Rul. 79-247, or payments to businesses.

Amounts Must be Received on Account of Physical Injury. Even if damages are paid as a result of tort or tort-type actions, they must also be received on account of physical personal injuries or sickness to be excluded from a recipient’s gross income.

Damages that Flow from Physical Injury. If a claim has its origin in a physical personal injury or sickness, then all compensatory damages that flow from that injury or sickness are payments received on account of physical personal injury or sickness.

Damages that Flow from Emotional Distress. IRC Section 104(a) specifically excludes emotional distress from the definition of physical injury or physical sickness, except where damages are paid for medical care attributable to such distress. This effectively eliminates the exclusion of payments arising out of claims for discrimination, breach of a fiduciary duty, malicious prosecution, defamation, wrongful discharge, intentional or negligent infliction of emotional distress. 

Physical Injuries that Flow from Emotional Distress. Damages for physical illnesses arising from emotional distress (e.g., insomnia, headaches, stomach disorders) are generally not excludable because they are considered mere symptoms of the underlying distress. The emotional distress resulting from the tort is not treated as a physical personal injury or sickness.

Emotional Distress Flowing from Physical Injury. Damages for emotional distress resulting from a physical injury are excluded from gross income. See Letter Ruling 200041022 distinguishing damages relating to physical injury from damages without physical injury.

This is the first in a series of articles on issues surrounding the Taxation of Settlements and Verdicts. The article addresses the initial question of whether these amounts are included in gross income.

General Rule. The proceeds from a settlement or verdict are part of the taxpayer’s gross income, unless the taxpayer can prove that the Internal Revenue Code provides for the exclusion of such receipts from gross income. IRC 61.

Origin of the Claim. The first step to determine the taxability of settlement or verdict proceeds is to determine the nature of the claims that were resolved or compromised. This is commonly referred to as the origin of the claim test. The critical question is: “In lieu of what were the damages awarded?”

Replacement of Wages. If compensatory damages are awarded as a replacement for income that would otherwise be fully taxable, then the damages are also fully taxable. Amounts received by an employee in lieu of payments under an employment contract are usually taxable as ordinary income, as long as they are not paid to compensate for a personal physical injury which is excludable from income in IRC Section 104(a)(2).

Replacement of Capital Property. Payments representing the replacement of capital are taxable to the extent that they exceed the basis of the replaced property, and then only as a capital gain. For example, recovery from a suit against a stock brokerage firm for losses in the value of stock.

Lost Profits. Payments for lost profits are ordinary income. For example, damage to business reputation; breach of contract; patent infringement; conspiracy to destroy a business; inverse condemnation; and, losses from negligent acts. Proceeds from an insurance policy that insures against lost profits, will also be taxable as ordinary income.

Goodwill. Where the underlying lawsuit is for injury to the goodwill of a business (a capital asset), the recovery represents a return of capital.

Damage to Property. If the payment is to compensate for the loss in the value of the physical asset, it is capital in nature. If the payment is to compensate for the loss of income from the physical asset, the payment may be taxable as the recovery of lost profits, that being ordinary income.

Overhead Expenses. Proceeds from a disability policy which pays for overhead expenses for a prolonged absence from the business are taxable as ordinary income.

Punitive Damages. Punitive damages are taxable as ordinary income, regardless of the character of the underlying claim.

Community Property. If the award is community property, only a portion may be included in the taxpayer’s gross income.

Payment of Legal Fees. The portion of the award that is for attorney fees is generally considered taxable to the plaintiff if the underlying claim is taxable. See Blog article on Attorneys Fees.

This is the fourth post in the Employment Tax Law series.  This series is dedicated to presenting individuals, sole proprietorships, and small to large businesses with a basic understanding of employment taxes, including the risks and responsibilities associated with those taxes.    

Deposit penalties occur when the taxpayer fails to make timely deposits, the timely deposits are made for less than what is owed, or the taxpayer fails to make the deposits in the proper manner (e.g. fails to use the EFTPS). For the amounts not properly or timely deposited, the applicable penalty rates are as follows:

a. 2% penalty for deposits made 1 to 5 days late.b. 5% penalty for deposits made 6 to 15 days late.c. 10% penalty for deposits made more than 15 days late. This also applies to amounts paid within 10 days of the date of the first notice the IRS sent asking for the tax due.d. 10% penalty for deposits made without a proper E.I.N.e. 10% penalty for amounts subject to electronic deposit but not made through the EFTPS.f. 15% penalty for amounts still unpaid more than 10 days after the date of the first notice the IRS sent asking for the tax due OR the day on which the taxpayer received notice and demand for immediate payment, whichever is earlier.

g. The IRS may assess an “averaged” failure to deposit penalty in cases where the taxpayer failed to report their tax liabilities. For a monthly depositor, this is the information on Line 17 of Form 941. For a semi-weekly depositor, this requires a Schedule B (Form 941).

Failure-to-file and failure-to-pay penalties mirror the penalties assessed for other late filed or unpaid federal taxes. For each whole or part month that a return is not filed, a failure-to-file penalty of 5% of the unpaid tax due with that return is assessed. The maximum penalty is generally 25% of the tax due. For each whole or part month that the tax is paid late there is a 0.5% failure-to-pay penalty. This amount is reduced to 0.25% if an Installment Agreement is in place. Like the failure-to-file, the maximum amount of this penalty is 25% of the unpaid taxes due on the return. If both penalties apply in any month, then the failure-to-file penalty is reduced by the failure-to-pay penalty. This applies only when the penalties are running concurrently.In the case of all of these penalties, the taxpayer can request to have the penalties abated, or, if provided soon enough, not assessed in the first place. To do so, the taxpayer must demonstrate to the IRS that there was reasonable cause for failing to file or pay. This explanation of the reasonable cause can be detailed in a Form 843, Claim for Refund and Request for Penalty Abatement.

 This is the third post in the Employment Tax Law series.  This series is dedicated to presenting individuals, sole proprietorships, and small to large businesses with a basic understanding of employment taxes, including the risks and responsibilities associated with those taxes.    

It is important that taxpayers make sure the correct Employer Identification Number (E.I.N.) is used for each Form 941. Using the incorrect E.I.N. can result in the assessment of penalties and further delays in the processing of the taxpayer’s return.

Should a taxpayer change addresses or names, notify the IRS immediately to avoid any issues with the processing of their returns. Please review Pub. 1635, Understanding Your E.I.N., to see if an application for a new E.I.N. is needed.

Make sure to check the appropriate box for the pertinent quarter. This will ensure the IRS properly accounts for the taxes withheld in each quarter. Seems like a basic rule, but this ministerial mistake trips up many taxpayers.

As for formatting, this is another potential trap for taxpayers, please be sure to complete the entries on the form as follows, to ensure accurate scanning and processing:

a. Use 12 point, Courier font (if possible), for all typed entries.b. Omit dollar signs and decimal points. Commas are optional. Report dollars to the left of pre-printed decimal points and cents to the right.c. Leave BLANK any data field (save for lines 1, 2, and 10) with a value of zero.d. Enter negative amounts using a minus sign (if possible), otherwise use parentheses.e. Place your Name and E.I.N. on all pages and attachments, stapling multiple page returns with a staple in the upper left-hand corner.

The frequency of a taxpayer’s deposits/payments is dependent on their total obligations during the lookback period. The lookback period is defined as four consecutive quarters of the prior year, with the final period ending on June 30. For example, the lookback period for 2009 started on July 1, 2007 and ended on June 30, 2008.Taxpayers that reported total taxes of $50,000.00 or less, for the most recent lookback period, are considered monthly depositors. Monthly depositors should make deposits for payments made during the previous month by the 15^th day of the following month. Taxpayers that reported more than $50,000.00 for the most recent lookback period are considered semiweekly depositors. Also, if you are a semiweekly depositor, you must complete and submit a Schedule B (Form 941) with each quarter’s Form 941.The deposit schedule for semi-weekly depositors is a bit more complicated. The general rule is that if the payday falls on a Wednesday, Thursday, and/or Friday, then the deposit should be made the following Wednesday. If the payday falls on a Saturday, Sunday, Monday, and/or Tuesday, then deposit the taxes by the following Friday. For more details on the deposit rules, see Section 11 of Publication 15.