Numerous tax consequences may arise when a taxpayer receives or pays a lawsuit judgment, award, or settlement. Unfortunately, attorneys representing taxpayers are often not extensively knowledgeable in the tax consequences of their actions. Therefore, it is common for practitioners or taxpayers to support their tax positions after their pleadings and legal documents have already been executed. As soon as taxpayers and practitioners become familiar with the tax consequences of lawsuits such as income inclusion, treatment of attorney fees, and Form 1099-MISC reporting requirements then the taxpayer or practitioner would be capable of advising their legal counsel on how to structure their lawsuit and/or settlement agreements.
Gerstenbluth v. Credit Suisse Securities, 728 F.3d 139 (7th Cir. 2013)
Chester Gerstenbluth was a former employee of Credit Suisse whom was relieved of his duties as an employee as a result of his age. As a result Gerstenbluth contacted the Equal Employment Opportunity Commission and as a result of their investigation Gerstenbluth received $250,000 as a settlement from Credit Suisse. As a part of the settlement agreement Credit Suisse retained the rights to withhold applicable tax withholdings, however the settlement agreement failed to specify the recognition of the $250,000 payment in regards to federal income and employment taxes.
The following calendar year Credit Suisse issued a W-2 while including the settlement paid as a part of his wages, tips, and other compensation while withholding the Federal Insurance Contribution Act (FICA) taxes. As a part of the IRC §3101, FICA taxes are imposed on wages (all remuneration) received as a result of employment. Chester argued that the settlement should not get included as wages and thus FICA taxes should not have been withheld and defined his settlement as a payment to withdraw his complaint of age discrimination. IRS Publication 4345 also states that a settlement regarding unlawful discrimination shall get reported as Other Income on Form 1040. Even though Gerstenbluth had a great argument, the court decided that his arguments were not good enough to change how Credit Suisse reported the settlement. This leads to an important consideration for taxpayers; unless a recipient can specifically define the recognition of a settlement then the recipient is at the mercy of the payer.
Gerstenbluth continued to argue the recognition of the settlement he received and eventually ran out of arguments while the court continued to rule in favor of Credit Suisse. Gertenbluth’s scenario demonstrates the importance for taxpayers and practitioners of understanding the tax implications of settlements, judgments, and awards.
IRC §62 states that all income is taxed regardless of the source. There is one exception, income derived from personal injury has been considered as a non-income item dating back to when 1919 as a part of the 16th Amendment. IRC §104(a)(2) also explains that a legal settlement or court ruling as a result of personal injury in not taxed. Whereas punitive damages are included in gross income regardless of whether they were received as a result of physical or non-physical injury; although there are exclusions available in relation to wrongful death cases (IRC §104(c)).
Treatment of Attorney Fees
The amount of attorney fees awarded must also get included within gross income regardless of whether the attorney fees were paid directly to the lawyers (543 U.S. 426 (2005)). A deduction is allowed for legal fees and court costs associated with the taxable amount of the money received, however the deduction is as a part of Schedule A (Itemized Deductions) as a Miscellaneous Itemized Deduction subject to the 2% Gross Adjusted Income (AGI) limitation. In addition, the Miscellaneous Itemized Deductions are a tax preference item for Alternative Minimum Tax (AMT).
Form 1099-MISC Reporting Requirements
The IRC §6041(a) and IRS Letter Ruling 8841033 in conjunction with one another allows for the determination that if a payer pays out an award that is not taxable to the recipient then the payer is relieved of the responsibility of filing Form 1099-MISC. However, based on Treasury Regulation §1.6041-1(f) for those payments to another person that are taxable, the payer must include the amount that will appear in the recipient’s gross income not reduced by attorney fees on Form 1099-MISC in Box 3. Whereas payments paid to an attorney regardless of the taxability of the payment must get reported on Form 1099-MISC in Box 14 as gross proceeds.
Deduction of Legal Expenses
There are several IRC sections relative to the deductibility of attorney fees including the following:
Adam Carr, MBA, EA