Personal injury claimants have many things to think about before settling a case. It often makes sense for claimants to prioritize non-tax over tax objectives (e.g., maintaining government benefits or avoiding premature dissipation). However, claimants should understand the tax consequences of their choices, and their advisors should ensure that they obtain any tax benefits that are available to them in light of their ultimate decisions.
Following are a few points that advisors to claimants sometimes miss when drafting settlement agreements:
State and Substantiate- The tax treatment of lawsuit proceeds depends on the intent of the payor. Thus, the settlement agreement generally should state the payor’s reason for making the settlement payment. Since the IRS and courts do not always respect statements made in settlement agreements, it is best to include recitals of facts that substantiate the payor’s reason.
Allocate and Substantiate- Some courts have held that if (1) any portion of a settlement payment is taxable and (2) the settlement agreement fails to demonstrate that a specific portion of the payment is nontaxable, 100 percent of the payment is taxable. Thus, a settlement agreement generally should state the specific amounts of a settlement payment that are made to compensate for particular injuries and include recitals of facts that substantiate the allocation.
Watch Out for Nontaxable Emotional Distress Damages- Although damages for emotional distress generally are taxable, they may be nontaxable if (1) the claimant’s emotional distress resulted from the claimant’s physical injuries or physical sickness, or (2) the claimant’s emotional distress resulted from another person’s physical injuries or physical sickness, or (3) the damages compensate the claimant for expected medical expenses (e.g., psychologist fees), or possibly (4) the emotional distress was so significant that it caused physical ailments observable by a doctor (e.g., a heart attack).
Avoid that 1099- Some courts have relied on a payor’s reporting of a settlement payment on Form 1099-MISC as a basis for holding that the payment was taxable. Thus, a settlement agreement generally should include a provision that prohibits the payor from issuing a Form 1099-MISC with respect to damages that the claimant believes to be nontaxable.
No time in a case is too early to be thinking about tax consequences. Even the selection of claims alleged in a demand letter or complaint can place a claimant in a better or worse position tax-wise.
