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Litigation Settlements Must Consider Taxation

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We constantly see media reports of a lottery winner's estimated net amount after taxes. This is a reminder that every financial event has tax implications. The Internal Revenue Code broadly defines taxable gross income as income coming from any source. Courts also broadly characterize funds that one receives as being subject to income tax while exclusions from taxable gross income are narrowly defined. A recent U.S. Tax Court decision determined that an employee's settlement of an emotional distress claim against her former employer was taxable income and not excluded from taxation as a worker's compensation claim (Sharp v. Commissioner). Apparently a careful allocation formula contained within the settlement agreement that divided the funds into various defined categories might have reduced the amount of taxable income.

The case in question involved a college professor who was demoted to a secretarial position after she reported missing equipment. After several other work related events, she was diagnosed with severe clinical depression, anxiety disorder and posttraumatic stress disorder. She brought two legal actions against her employer. One action was for worker's compensation and the second was for gross negligence. The settlement agreement in question stated that it was for "emotional distress damages only." Subsequently she had a dispute with the IRS concerning the taxation of the settlement proceeds.

The Court noted that the taxpayer has the burden of proof when the IRS characterizes funds as taxable income. However, worker's compensation payments for personal injuries are excludable from taxable income. In determining what the financial settlement in question was for, a court will typically only consider the language of the settlement agreement. While the settlement contained a vague reference to it being conditioned upon settling the "W.C. claim," the Court determined that this was insufficient to exclude the funds from taxable income.

While damages received for personal physical injuries or physical sickness may be excluded from taxable income, the burden of proof again rests upon the taxpayer. The Court decided that the settlement language "for emotional distress damages only" was not clearly proven to refer to trauma directly resulting from physical injuries. Numerous judicial decisions indicate that financial settlements for emotional distress that has physical manifestations are taxable gross income. Lastly, the Court concluded that the taxpayer was a professional accomplished woman and that she failed to demonstrate that she believed her attorney to be a competent tax advisor. This proof might have allowed some relief from a tax penalty under a good-faith reliance argument.

This decision demonstrates the vital necessity of having a clearly certified or defined tax professional involved in settlement agreements. The decision additionally indicates how the language contained in the settlement agreement may have significant tax implications. Finally, one must realize that the burden is on the taxpayer who seeks to exclude settlement proceeds or any other revenue received from taxable gross income.