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.