By Stephen J. Turanchik
Mr. Turanchik is an attorney at Paul Hastings LLP. His practice focuses on federal and state tax litigation and controversy matters.
Parties to an employment lawsuit will oftentimes spend hours, if not days, in settlement discussions. Quite frequently, it is only after an agreeable (or perhaps unagreeable) settlement has been reached that the counsel for the parties ask, "What about taxes?"
The appropriate tax treatment for a settlement depends upon the claims at issue in the dispute. Stated differently, what was the recovery paid in lieu of? Courts have referenced this approach as the origin of the claim doctrine.1 The basis for the claim will determine the appropriate tax treatment of the settlement payment.
To evaluate the nature of the claims brought by a plaintiff,2 the IRS will look to the allegations in the complaint or statements made in written demands. As discussed below, the IRS and courts will also look to the language of the settlement agreement to assess the claims that were settled between the parties.
It is well settled tax law that gross income generally includes all income from whatever source derived.3 The definition of gross income is broad in scope, while statutory exclusions from income are narrowly construed.4
In labor and employment lawsuits, the overwhelming majority of the payments on claims will be taxable. The result is that the majority of tax issues faced at the settlement stage involve allocating between wage claims and non-wage claims. The consequence is that the employer is required to withhold income and employment taxes from wage payments, but non-wage payments are not subject to withholding. For the claimant, allocating amounts to a wage claim means a smaller "take-home" amount. Typical wage income includes back pay (other than lost pay for personal physical injury) and front pay.5 Typical non-wage income includes payments for emotional distress (from discrimination, injury to reputation, etc.), costs, punitive damages, and interest (taxable as interest).
As discussed more fully below, payment of the claimant's attorney's fees by the employer will result in income to the claimant even if paid directly to the attorney.
In 1996, Congress amended Internal Revenue Code (IRC) section 104(a) to exclude only personal physical injury and personal physical sickness from gross income. Prior to the law change, all personal injuries (both physical and emotional) could be excluded from gross income.
The legislative history of section 104(a) makes critically clear that neither emotional distress nor physical symptoms of emotional distress are physical injuries. "It is intended that the term emotional distress includes symptoms (e.g., insomnia, headaches, stomach disorders) which may result from such emotional distress."6
Although rare, claims for personal physical sickness and personal physical injuries can arise in employment-related matters. Amounts received for those claims are excludable from the claimant's gross income if (1) the claim was based upon tort or tort-type rights, and (2) the damages were received on account of personal physical injuries.
The IRS takes the position that observable or documented bodily harm - such as bruising, cuts, swelling, or bleeding - is evidence of personal physical injury,7 although the IRS has softened this position at times.8
When a claim is based upon personal physical injury or personal physical sickness, and the physical injury or physical sickness causes the taxpayer to suffer emotional distress, then the payment is excluded from damages allocated to such emotional distress.9 Thus, in determining the taxability of emotional distress, one can view the source of the injury as determining the taxability of the payment. If the physical injury was a manifestation of emotional distress, the recovery is taxable. If the emotional distress arises from a personal physical injury, then the recovery is non-taxable.
Cases have primarily focused on personal physical injury and not personal physical sickness. However, two relatively recent cases tackled the issue of whether the taxpayer received payment for physical sickness.
In Domeny v. Commissioner,10 the taxpayer suffered from multiple sclerosis...
