Ever since the Supreme Court decision in Commissioner v. Schleier, the vast majority of employment settlements have been deemed taxable. Attempts to get employment recoveries excluded from income have all met with failure with few exceptions.
There have been a number of changes to the tax code and cases addressing taxation of damages in the last few years. Given this, and as tax rates increase, at some point in the settlement process the tax consequences of the damages should be examined. After all, a settlement that is fully taxable to the claimant results in fewer dollars than a claim that is tax deferred, partially taxable, or tax exempt. Even a simple allocation between wages and non-wages can make a significant difference in how much a claim settles for. Even beyond that, the ability to use structured settlements (periodic payments) to lower the amount the claimant loses to taxes can achieve a better bottom line outcome and get claims settled for a reasonable amount.
Compensation for personal physical injuries or sickness is excluded from income under Section 104 of the Internal Revenue Code. The Small Business Job Protection Act of 1996 (the “Act”) was aimed at employment claims and restricted the scope of Section 104 to physical, as opposed to personal, injuries. The Act also singled out emotional distress injuries, providing that they are not considered a physical injury or sickness, even when those emotional distress injuries that result in physical symptoms, such as headaches and ulcers, firmly closing the door on the possibility that purely emotional or mental injuries that do not originate in a physical injury be excluded from taxation.
The IRS has had occasion to rule at least once on what constitutes a physical injury. In PLR 200041022, the Service held that in a sexual harassment case only damages that resulted in an “observable physical harm” would receive tax exempt treatment under Section104. All other damages from the harassment claim were held to be includable in gross income. While there have been dozens of cases in Tax Court trying to include emotional distress or its manifestations (ulcers, migraines, bruxism, etc.) under Section 104, the courts have consistently ruled these damages are taxable.
There are a few exceptions, such as the exclusion for medical expenses, even on emotional distress injuries, as defined under Section 213(d) of the Code. For example, psychiatric care stemming from a sexual harassment incident would fall under Section 213 and be excludable from income.
Given that employment-related recoveries are generally taxable, the question becomes how do the negative tax ramifications of a settlement help a claims handler? In many cases the answer is to settle the case with a structured settlement or periodic payment plan as opposed to a lump sum.
As a general rule it is most often advantageous to receive and be taxed on income in a later tax year rather than an earlier tax year. It makes far more sense to defer recognition of income, than to receive large sums of money at once and pay taxes at a higher rate immediately. For example, the tax consequences of a $500,000 recovery spread into ten equal installments over ten years is substantially less than the tax consequences on the payment if it is all received and taxed in one year. The concept of deferred income recognition has been around for decades with deferred compensation agreements for highly compensated executives.
By dealing with the taxation issues through a structured settlement consultant, the claims handler can negotiate for periodic payments that result in a much better outcome from an income tax perspective for the claimant. A structured settlement consultant versed in taxable damage issues can help the claimant avoid certain pitfalls like constructive receipt and improper allocation. Making the claimant aware of these issues, and how deferring the taxation of all or part of the award can be done through a structured settlement, enables the claim to be resolved sooner.
For example, let’s say the demand to settle a harassment claim in California is $400,000 (not including attorney fees). Without adjusting the tax liability for deductions and credits, the federal tax liability would be 35 percent, and the state tax liability 9.3 percent if the claimant were to receive the $400,000 in a lump sum, losing over $177,000 to taxes immediately. Instead of a lump sum, let’s say the defense offered to pay him $40,000/year for 10 years, at a cost of $360,000. By spreading payments out over a ten-year period, the claimant will lower their tax bracket to 25 percent federal and 6 percent state, all while earning money on the 44.3 percent that would have been lost to taxes. It is this deferral that allows for higher net dollars to the claimant than an equivalent amount paid in cash. Plainly stated, by using periodic payments, a defendant can pay less but a claimant will receive more.
The tax consequences of a settlement or judgment should be considered in every taxable case (not just employment litigation) of significant size. The tax characterization can have a dramatic effect to the parties involved in litigation. From a practical standpoint, the failure to consider the tax consequences of a damage award by counsel can result in a legal malpractice claim.
It is vitally important to examine the tax ramifications of a recovery in the employment context and explore viable alternatives to improve the chances of settling the claim. The use of periodic payments for taxable damages allows the claimant to achieve a better bottom line outcome by taking advantage of deferred recognition of income. Structured settlement consultants who specialize in taxable settlements are a free resource available to any claims handler or risk manager and can help make a significant financial difference when settling employment and other taxable claims.
Commissioner v. Schleier, 515 U.S. 323, 132 L. Ed. 2d 294, 115 S. Ct. 2159, 95-1 U.S. Tax Cas. (CCH) ¶95-2675, 95 T.N.T. 116-8 (1995)
McCulloch is the vice president of Advanced Marketing for Integrated Financial Settlements and a settlement consultant with EPS Settlements Group. His expertise is in the taxation of damages and he has obtained two rulings from the IRS on using periodic payments to settle claims. His office is located at 36 W Randolph St., Suite 600, Chicago, IL 60601. He can be reached at 630-864-8420 or by email at firstname.lastname@example.org
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