Strategies for Settlement

How looking at the tax code can help you save

February 03, 2023 Photo

It is time to consider new ideas and strategies to help you settle claims. In that spirit, this article will share strategies that allow you to settle by giving more and spending less. How is this possible? The secret is in the tax code.

The default position for the IRS is that all income is taxable. Good planning can result in better tax treatment, and the way to better the tax treatment of lawsuit recoveries can be accomplished by memorializing the case facts in the settlement agreement.

For example, you might have an employment case where a component of the alleged damages is for emotibonal distress. In this type of case, taxes could decrease if the wording in the settlement agreement specifies the amount of the recovery that is allocated toward plaintiff’s medical expenses. Or, if the claim is for physical injuries, specifying the amount of the recovery allocated to future medicals could allow the plaintiff to deduct future medical expenses paid out of pocket. In both cases, the wording in the settlement agreement can save the plaintiff a significant amount on taxes. This savings can benefit defendants and plaintiffs—defendants spend less and plaintiffs keep more. Everybody wins.

Defense Influence on Settlement Taxes

IRS rulings and tax court decisions provide clear guidance that, often, it is the defendant that controls plaintiff taxation. Here are three examples:

  • In Green v. Commissioner, 507 F.3d 857, 868 (5th Cir. 2007), the tax court said that “the character of the [settlement] payment hinges on the payor’s dominant reason for making the payment.” The first place the court will look for the “dominant reason” is the language of the settlement agreement. [See Greer v. United States, 207 F.3d 322, 329 (6th Cir.2000)].  
  • The IRS default position is that the taxpayer has the burden of proof upon an IRS challenge. However, per IRC § 7491, a showing of credible evidence shifts the burden to the IRS. The tax court has said that language in a settlement agreement is credible evidence. Therefore, defendant’s agreement to language can provide significant protection to the plaintiff. (See Forste v. Commissioner, T.C. Memo 2003-103).
  • Finally, in Connoly v. Comm’r, T.C. Memo 2007-98., the IRS said it will use a defendant’s reporting of a settlement as proof of defendant’s intent. This means when a defendant decides to report a recovery as taxable, the plaintiff must do so as well or face a significant risk of audit

So, the question is, can a defendant provide this benefit to a plaintiff without assuming risk? The answer is yes.

Avoiding Defendant Liability

When we talk to defendants about how to use tax strategies to help settle cases, the main concern we hear is one of liability: 

  1. Defendant’s liability to the plaintiff in giving tax advice—This one is easy because you likely already protect yourself. The settlement agreement will state that the plaintiff has not received and will not rely on the defendant for tax advice.
  2. Defendant’s liability for IRS penalties—The exposure here relates to issuing 1099s. Per IRC § 6721(a)(1), defendants are required to report the taxable portion of a recovery. The penalty for failure to do so is $250. We are not aware of the IRS asserting this penalty against a defendant in a non wage case, probably because defendants have significant discretion as to why they make a payment. In addition, defendants are relieved of the obligation to issue a 1099 when they do not have enough information to determine the taxable portion. (See IRS Rev. Rul. 80-22). 
  3. Defendant’s liability for under-withholding—There is real exposure here. The defendant will owe the defendant’s and the plaintiff’s share of employment taxes if the IRS proves that the defendant failed to withhold on the appropriate amount of wages at settlement. Employment lawyers and adjusters that work  these claims deal with this issue daily. If handled correctly the risk is minimal.

Many Ways to Give and Save

Every case is different, and so are the strategies. The general process is to (1) identify possible tax benefits based on case facts, and (2) memorialize those facts in the settlement agreement. Following are several examples:

Physical Injury—Maximizing Medical Deductions. Typically, lawsuit proceeds paid on account of personal physical injuries are received income-tax-free. [See IRC § 104(a)(2)]. Thus, a plaintiff is unlikely to owe tax unless her settlement compensates for punitive damages, interest, previously deducted medical expenses, or abiding by a nondisclosure agreement—which are all taxable.

But, allocating a reasonable portion of settlement proceeds to future medical expenses may save the plaintiff significant future taxes. Without doing so, she may be unable to deduct medical expenses related to the case until she has spent the full amount of the recovery on medical expenses. (See IRS Rev. Rul. 75-232). In a paraplegic case, for example, this could increase the plaintiff’s taxes by millions of dollars.           

Emotional Distress—Avoid Tax on Legal Fees. Like proceeds from many other claims, a recovery for emotional distress is generally taxable. In taxable cases, the plaintiff is taxed on the amount she keeps and also on the amount she pays to her lawyer [See Commissioner v. Banks, 543 U.S. 426 (2005)], unless she can deduct her legal fees. Unfortunately, as of 2018, plaintiffs generally cannot deduct their legal fees except in employment and classic civil rights cases. [See IRC § 67(g), 62(a)(20)]. Because the rule causes plaintiffs and counsel to pay tax on the same amount, some call it a “Double Tax.”

To avoid the Double Tax, some plaintiffs transfer their claim to a litigation trust similar to a charitable remainder trust. The trust pursues and recovers on the claim, pays plaintiff counsel their legal fee, and distributes the remainder to the plaintiff. For a plaintiff paying tax at a 40% rate, and a contingency fee of 40%, such a trust can reduce taxes on a $1 million settlement by $160,000. Given the size of the Double Tax, the trust’s savings can radically increase what the plaintiff keeps.          

Claims Affecting Family Members—Reduce Income and Estate Taxes. Claims of all sorts affect a plaintiff’s family, and that fact offers tax planning opportunities. When a former plaintiff receives nursing care from a family member, and pays for it, those payments are taxed as compensation for services. However, if that family member receives settlement proceeds as a co-claimant, she can likely avoid substantial taxation.

When an already-settled plaintiff dies and passes on cash or future payments from the settlement, her estate pays estate tax on amounts above the threshold, and possibly generation skipping tax. However, those amounts avoid taxation if the would-be beneficiaries instead receive such amount as co-claimants in the settlement.

Whether family members and other beneficiaries can receive settlement proceeds as co-claimants is highly fact specific. And, in some states, statutes and common law may obstruct their claims for emotional distress, loss of consortium, or loss of society. However, if a claim could conceivably succeed, the defense is justified in paying to extinguish it. Thus, by considering possible co-claimants, settling parties can reduce both income and estate tax.

Capital Claims—More Income at a Lower Rate. Settlement proceeds from capital-related claims are taxed based on their reason for payment and the “origin of the claim.” A plaintiff pays less if she can treat the proceeds as a combination of (1) a recovery of cost, and (2) capital gain, rather than (3) lost profits (for example, if a business sues an investment banker for breach of contract after multiple delays by the banker resulted in the plaintiff raising less capital and generating less profit because of a slower economy). The plaintiffs will pay less tax if the settlement agreement reasonably allocates more of the recovery to diminution in value and less to lost profits. Diminution in value will be taxed as capital gain, and only in excess of basis.

Structured Settlement—Tax Free or Tax Deferred Payment Stream. Plaintiffs can obtain tax advantages through structured settlements (i.e., payments over time), which take a variety of forms. Typically, in a structured settlement, the defendant is permanently released from liability in exchange for facilitating the plaintiff’s indirect investment in annuities or market-based products. The funding vehicle will pay plaintiff periodic payments on a tax favored basis.

Due to the recent rise in interest rates, payouts from structured settlements have increased. Almost overnight, plaintiffs’ interest in structured settlements has also increased. Structured settlements are once again seen as a valuable settlement tool that can help settle claims.

Don’t Forget About Insurance Coverage and Definitions

Settlement tax treatment is often centered around whether or not a claim is for “bodily injury.” Often insurance policies require “bodily injury” to exist in order for coverage to apply. Under the tax code, generally, “bodily injury” must include an observable physical injury (bruise, cut, etc) in order for settlement proceeds to be income tax free. Observable physical injury may or may not be required for a claim to be considered “bodily injury” and qualify for coverage under an insurance policy.

Can you have a situation that qualifies as bodily injury under an insurance policy and does not qualify as bodily injury under the tax code? The answer is: definitely, yes.

Tax is technical and defendants and plaintiffs avoid thinking about it even when significant savings are available. This article focused on the first step: recognizing the opportunity. We believe that settling parties that are aware of the opportunity can settle for less and keep more.   

About The Authors
Multiple Contributors
Don Engels

Don Engels, CLU, AIC, CSSC, associate with Ringler Associates, is president of The Settlement Tax Group.

Maxwell Brusky

Maxwell Brusky, JD, is assistant branch manager, major case unit, at Gallagher Bassett Specialty – Transportation.

Dan Misheck

Dan Misheck is complex claim specialist at EMC Insurance Companies.

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