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What Forensic Accountants (and the Attorneys They

Advise) Must Know About Taxes on Damage Awards

Abo and Company, LLC


Abo Cipolla Financial Forensics, LLC

Certified Public Accountants / Litigation & Forensic Consultants


Website: www.aboandcompany.com

South Jersey Office (correspondence)


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Mt. Laurel, NJ 08054
(856) 222-4723

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New York NY 10019 (201) 490-1117 (215) 736-3156 (215) 736-3156
Melville NY 11747
(212) 495-0400 (631) 271-8600

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Martin H. Abo, CPA/ABV/CVA/CFF is Managing Member of Abo and Company, LLC – Certified
Public Accountants. He is co-managing member of Abo Cipolla Financial Forensics, LLC, an
affiliate of the core accounting firm exclusively providing expert witness testimony on financial
matters and other litigation support services and business valuations.

Marty has comprehensive experience in individual and corporate financial, business and tax
planning. His experience includes several years with the tax department and audit staff of a Big
Four CPA firm and regional firms before he founded the present enterprise. Marty has
developed a specific expertise in performing dispute resolution and other consulting services.
Clients, and the banking, insurance, judicial and legal community, increasingly call upon him to
provide technical assistance, arbitration or expert testimony on financial accounting matters,
business valuations, structuring buy-ins and buy-outs, divorce, estate controversies, insurance
claims and other forensic/investigative analysis covering a wide range of topics and industries.
He has operated in a supportive capacity to attorneys, judges, adjusters and clients in providing
ongoing facilitation in the negotiation and/or litigation process. Marty assists attorneys to
strengthen their cases by clarifying language and economic concepts, preparing useful exhibits
and reports, and testifying as an expert witness.

A graduate of Syracuse University, Marty is an active member and chaired for several years the
Litigation Support & Forensic Accounting Interest Group of the New Jersey Society of CPAs.
Marty holds the professional designation of Certified Valuation Analyst from the National
Association of Certified Valuators and Analysts and has been awarded the designation of ABV,
Accredited in Business Valuation, and CFF, Certified in Financial Forensics, by the American
Institute of CPAs.
Marty volunteers his time and expertise to many other business and professional organizations:
he had served as a director of a local bank and, 14 times, had been one of 150 participants
selected by the S.E.C. from CPAs, lawyers, bankers, venture capitalists and economic
development experts, from across the nation for its annual conference on issues of Small
Business Capital Formation. He was selected a NJ delegate to the White House Conference on
Small Business under two U.S. Presidents while the Small Business Administration had named
him "Accountant Advocate of the Year". He serves as a Director of Deborah Hospital
Foundation; serves as a Director of the Society of Financial Service Professionals-South Jersey
Chapter; is an active member and served as President of the Estate and Financial Planning
Council of Southern New Jersey; is an active member and served as a Director of the Chamber
of Commerce of Southern New Jersey; he serves on the Matrimonial Accounting Interest Group
of the NJSCPA; and had served as a special advisor to the New Jersey Small Business
Development Centers. Marty is a director and treasurer of Exit Planning Exchange-Philadelphia
(XPX), whose members include estate planning attorneys, CPAs, investment bankers, wealth
management advisors, commercial lenders, executive coaches, M&A attorneys, marketing and
management consultants and former business owners who now advise fellow business owners
on exit planning.

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Considerations Pre-1995 and Forward

For years, confusion and litigation abounded about the taxability of punitive damages and
damages for nonphysical injuries such as gender and age discrimination or in harassment
cases. Internal Revenue Code (IRC) section 61 states that all income from whatever source
derived is taxable income, unless specifically excluded by another code section. The only
provision which specifically addresses income exclusions for any type of lawsuit proceeds is
IRC section 104(a)(2) which excludes from income amounts paid by suit or agreement for
personal injuries or sickness. When the Small Business Job Protection Act was signed into law
in 1996, years of litigation ended by stating that punitive damages – whether or not related to
physical injury – are not excludable from gross income. Awards for nonphysical injuries are not
excludable except for amounts paid for medical care attributable to emotional distress. The
legislative history of the 1996 Act, as it related to IRC section 104(a)(2), provided useful insight
into what was or was not excluded from taxable income because of "physical injuries or physical
sickness". Generally, if the primary injury is physical, then all resultant damages (once again,
except for punitive damages or interest) are excludable. This is the case even if the damages
are measured by lost wages. However, if the primary injury is not physical, then the resultant
damages are not excludable even if the action caused emotional distress, which might cause
headaches, ulcers, teeth grinding, insomnia, etc. It's interesting to note in the Conference
Report that injuries resulting to other third parties are excluded if the underlying injury was
physical (i.e. loss of consortium or recoveries for wrongful death).

Also excluded from taxable income are recoveries to pay for medical expenses resulting from
the personal injury. Such would include medical care necessitated by a non-physical injury (i.e.
psychiatry or therapy for emotional distress resulting from a wrongful discharge, medicines for
resulting stress, dental bills resulting from teeth grinding, etc.).
Consider:
 Punitive damages will generally be included in gross income and taxed when received
because of personal injury or sickness whether or not related to a physical injury or
physical sickness. For example, Tax E. Vater was awarded by the jury $200,000 for

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physical injuries received from an accident at his job. $150,000 of the award was
attributable to his actual physical injuries while the balance was punitive because of
Considerations Pre-1995 and Forward (cont'd)
repeated OSHA violations at his employer’s factory. Tax E. Vater should include the
$50,000 punitive portion of the award in his taxable income while the $150,000 payment
for his actual physical injuries can be excluded.

 Damage recoveries for other than physical injuries or sickness will be taxed. Emotional
pain and suffering or emotional distress is not considered a physical injury or illness
excludable from taxation. Other than for the actual medical expenses incurred, damages
received for "wrongful discharge” claim, race and age discrimination, injury to reputation
accompanied by a claim of emotional distress, and similar non-physical claims will all be
included in gross income. For example, her employer awarded Jane Denim $70,000 for
sexual harassment. The entire award was for her pain and suffering but because the
award was for a non-physical injury, the entire $70,000 would be taxable. A recovery for
back pay is generally treated in the same manner as the salary or wage payments it
replaced and therefore taxable as ordinary income. However, in the context of a physical
injury suit the IRS has treated even amounts attributable to wage loss as excludable
under Section 104.

 I indicated that damage awards (non-punitive) received because of physical injury or


sickness will not be taxed. Similarly, awards for emotional distress or other non-physical
injuries to the extent attributable to a physical injury will be excluded. In this first
instance, if Sally Jones received $50,000 for physical injuries she received in a car
accident, she would not be taxed on anything since the entire amount was for the actual
physical injuries she suffered. As you can see, the physical personal injuries do not have
to occur to the recipient of the damages award to be excludable under 104(a)(2). Again,
as long as the claim has its origin in a physical injury or physical sickness, then all
damages (except interest thereon or punitive damages) that flow are excludable whether
the recipient is the injured party or not. Two examples were cited in the Conference
Committee Report for section 104. First, damages received by an individual for loss of
consortium due to the physical injury or physical sickness of his (her) spouse is

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excludable. In our illustration, if her husband received another $30,000 for his loss of
consortium with Sally resulting from her injuries, the entire award would still not be
Considerations Pre-1995 and Forward (cont'd)

taxed because the award had its origin in a physical injury. The second example cited in
the Committee Report, damages received on a claim for a wrongful death, are also
excludable.

 Non-punitive awards for non-physical injuries will not be taxable to the extent they are
paid for medical care attributable to emotional distress. For example, Jane Martin was
granted $100,000 from a jury for her sexual harassment claim. If $20,000 of the award
was to reimburse her for the medical expenses due to her treatment of the emotional
distress caused by the harassment, only $80,000 of the award for her pain and suffering
would be included in income.

 It is now well settled that interest included in a judgment that has become final will be
treated as taxable interest, not to be excluded under IRC sec 104(a)(2). Concerns
develop where an out of court settlement occurs with the settlement agreement silent as
to interest. IRS typically argues that some portion of the lump sum payments represents
interest income taxable to the Plaintiff while the taxpayer Plaintiff will claim that the entire
settlement should be excluded under 104(a)(2) as damages received “on account of
personal injuries”. Attorneys should state in their settlements that the award is "without
interest" although such a practice is not decisive. While there may be an assumption
there is no interest income component in a lump sum personal injury settlement reached
before the actual trial, appreciate how easy it is for the IRS to glean from a jury verdict,
which specifies compensatory damages with stated interest computations. Structured
settlements (i.e. damages awards where the defendant typically pays a lump sum to a
financial intermediary that makes periodic payments to the plaintiff) received because of
a personal physical injury will enable the recipient to exclude the entire periodic
payments, even though such payments include an interest element. Section 104 makes
no distinction between damages received as lump sums or as periodic payments, so
each payment should be 100% excludable from income. Although the additional monies

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attributable to time delays or earnings on investments might be viewed by us as interest,
each payment

Considerations Pre-1995 and Forward (cont'd)

should be tax-free. If the recipient receives a lump sum any investment earnings would
thereafter be taxable.

 The water is still murky on exactly what is a “physical injury”? Are ulcers? Are migraines
or cluster headaches? Are strokes? Reading the legislative history in the Conference
Committee Reports to the 1996 law changes revealed that mere symptoms of emotional
distress such as stomachaches, headaches or insomnia do not constitute physical
injuries although these three examples were not meant to be all-inclusive. As we stated,
recoveries based on wrongful termination claims, discrimination-based claims or the like
are generally not excludable even when employees have grounds to argue that some of
their recovery is for personal physical injuries or physical sickness. At a minimum, to
overcome this presumption there should be language that suggests recovery was
because of physical injury or physical sickness.

 A properly worded complaint or settlement agreement can aid in excluding the damages
from gross income. Not considering the tax consequences of a damages award can
easily lead to a malpractice claim against the erring attorney. Regardless, I would ask my
attorney colleagues to consider this scenario: a driving instructor suffers physical injuries
when he failed to follow standard operating procedures with the company vehicle under
his control. The employer terminates his employment contract for breach of their rules.
The employee then sues and assume the company agrees to settle for $100,000. The
employee’s attorney may artfully craft the settlement agreement to specify that the
employer is paying for the personal physical injuries suffered by the employee, hoping to
avoid taxation of the proceeds. Although such drafting of the settlement agreement is not
conclusive, leaving it open or vague only leaves the IRS an opportunity to easily
challenge such treatment. For example, the Service may claim that the $100,000 was to
compensate the employee for the "wrongful discharge", which would make the proceeds

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taxable. Properly wording the initial complaint and the settlement agreement or even
asking the Court to allocate the damage awards is the best way to help ensure favorable
tax treatment. If the

Considerations Pre-1995 and Forward (cont'd)


recovery is under a judgment, the judgment itself may allocate the award although
common practice is to avoid this issue because in either instance the IRS is not bound to
the determination for tax purposes. If the recovery is under a settlement, the settlement
document should include an allocation, although that allocation is not itself necessary to
secure the suggested tax treatment. If no basis is demonstrable, the entire amount is
treated income. As a CPA, I would imagine trying to substantiate the tax treatment in the
complaint is further complicated since the plaintiff’s lawyer often considers several
theories/claims. Still, the IRS often relies on the initial complaint as the most persuasive
in allocating damage awards (usually in their favor and not the Plaintiff's).

 Amounts received under workmen’s compensation acts as compensation for personal


injuries or sickness are not taxable.

What’s it all mean? Sometimes, it's been noticed plaintiffs holding out for more money to make
up for an increased tax liability. Also, some lawyers believe a greater number of claims have
been made alleging physical injuries in some harassment or discrimination cases. Attorneys
may wish to seek the help of CPAs to help them analyze and quantify claims for damages or
settlement offers. By discussing with the accountant or tax attorney the tax or financial impact
of filing a claim under several scenarios, consideration can be given to maximizing the after-tax
recovery. CPAs also might consult with defense counsel, preparing reports or counter-reports
where necessary, and even advising them on settlements of legitimate claims that might
minimize income taxes, which could cause lower payments by the attorney's clients/payors.

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Then Came an Interesting Case:
Marrita Murphy, et al, v. Internal Revenue Service, et al

Marrita Murphy was awarded compensatory damages for emotional distress and reputation
loss when she sued her former employer under the whistle blower statutes then in effect for
emotional distress and physical damages resulting from her employer’s retaliation and illegal
treatment (or mistreatment). The initial award from an Administrative law judge and affirmed
by the Department of Labor Administrative Review Board was for compensatory damages of
$70,000. $45,000 was for “emotional distress or mental anguish” and the balance, or
$25,000, was for “injury to her professional reputation”. Ms. Murphy reported and paid tax
on the full award. She later filed an amended income tax return seeking refund of $20,665.
When the IRS denied her claim she sued in the U.S. District Court for the District of
Columbia to obtain refunds for these taxes she paid on the compensatory damages for
emotional distress and reputation loss. As I discussed earlier, such damages for emotional
distress are not specifically excluded under section 104 and were considered taxable by the
Service. The taxpayer plaintiff, challenging its constitutionality, argued that damages paid
regarding non-physical injuries are not “income” and also argued her award should not be
taxed because she suffered from physical manifestations of her "mental" injury. The District
Court rejected her plea and, after appealing, on August 22, 2006 the Court of Appeals
agreed that Ms. Murphy’s damages for emotional distress were NOT “income” and were
NOT taxable. The Court found an award limited to making someone "whole" for actual
documented losses to physical or mental health was not taxable.

The three judge Court of Appeals decision was only binding on the IRS with similar cases in
Washington DC but it was startling to the tax community as having a significant "rippling
effect", especially for any cases anticipating damage awards for “non-physical or
emotional/mental injuries”. One could easily see how plaintiffs and their attorneys would
likely move quickly for similar decisions in other circuits, opening up the proverbial
"floodgates" for so much litigation. The Appeals Court came under tremendous pressure

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from various federal agencies, judiciary, the accounting and legal communities. For those
who can't easily grasp the significance, the cost of settlement will inevitably go up when the
taxing authorities want their "piece of the pie”.

Then Came an Interesting Case:


Marrita Murphy, et al, v. Internal Revenue Service, et al (cont’d)

Plaintiffs will accept lesser "gross" awards if there are less or no income tax strings attached
while, conversely, the defendant or his (her) insurer must come up with less money, as well.
After the 1996 changes which clarified that emotional distress damages are taxable, it
became that much more difficult to settle cases. We at Abo Cipolla Financial Forensics,
sitting on the sidelines after Murphy, saw, perhaps for the first time, the plaintiff’s bar in full
agreement with the defense bar.

What a difference a year makes

Fast forward from August 22, 2006 in Murphy to July 3, 2007. Well, in a remarkable reversal
of its prior decision, the same court later accepted that any non-physical award should be
fully taxable. The Department of Justice asked for a hearing en banc (i.e. a hearing before
all the members of the Court rather than before only the panel of three judges who made the
original decision). That same Court vacated its original August 2006 judgment. I’ll leave it to
constitutional rights advocates and employment lawyers to argue the intrinsic merits of the
government’s new arguments. For us and other tax practitioners, we’re left to follow what we
initially envisioned after the 1996 tax law and before the initial Murphy decision. There is no
difference where the origin of the claim is a personal physical injury. The actual wording of
the initial order from the Administrative Law Judge was so very critical by his use of phrases
like “emotional distress or mental anguish” and “injury to professional reputation”. These
words effectively put the nail in the coffin for the argument that exclusion under section 104
(a)(2) applied by its terms, with the IRS emphatically arguing that Ms. Murphy's injuries were
not physical.

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I can think of two important lessons to be learned that the Murphy verdict teaches us. First,
settlement may well be better than a verdict, giving the plaintiff taxpayer greater flexibility in
structuring a settlement tax-wise. In addition, counsel can just not be concerned enough
over using exacting wording in that perhaps “on account of” is not as clear as one would
think (i.e. “on account of physical injury”).
Some Additional Thoughts on Where We Are
 Absent a specific allocation in a settlement agreement, courts (and the IRS) will look to
the plaintiff’s complaint and the intention of the payor to allocate an award among various
asserted claims. According to the IRS’ audit guide for Lawsuit Awards and Settlements
“…many lawsuits are settled prior to a jury verdict. These settlements should be closely
reviewed, and facts and circumstances should be carefully determined. The allocation
among the various claims of the settlement can be challenged where the facts and
circumstances indicate that the allocation does not reflect the economic substance of the
settlement.”

 A bona fide arm’s-length settlement agreement among adverse parties allocating specific
amounts to specific claims should be honored by the IRS although they are not bound by
the parties’ allocation and may challenge an unreasonable one. According to the IRS’
audit guide “…if damages have been clearly allocated to an identifiable claim in an
adversarial proceeding by judge or jury, the Service will usually not challenge their
character because of the impartial and objective nature of the determinations."

 On a related note, plaintiffs’ bar as well as the defense bar should be cognizant that
confidentiality provisions can also be considered taxable income. Previously, personal
injury settlements that contained confidentiality provisions were believed to be fully
excluded from taxable income as with the rest of the settlement (except for an interest or
punitive component) income under section 104(a)(2). The U.S. Tax Court, with its
decision in Amos v. Internal Revenue Service, gave its blessing to the IRS in taxing a
portion of the settlement proceeds from the physical personal injury award as attributable
to the confidentiality provision. Given the Amos decision, plaintiffs and their attorneys
should be very cautious when agreeing to personal injury settlements that include
confidentiality clauses. They should at least ensure that the tax issues have been

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considered and properly addressed if these provisions must be so included. Plaintiff
lawyers are therefore well advised to commence any negotiations, right at the start,
noting that such confidentiality provisions be stricken. If plaintiff attorneys can't eliminate
such confidentiality clauses at a minimum, they should seek to keep the language tight
since defense attorneys frequently put in such clauses automatically.
Some Additional Thoughts on Where We Are (cont'd)

 According to the IRS audit guide “…claims for wrongful death usually encompass
compensatory damages for physical and mental injury, as well as punitive damages for
reckless, malicious or reprehensible conduct. As a result, both claims may generate
settlement amounts. Any amounts determined to be compensatory for the personal
injuries are excludable from gross income under section 104 (a)(2). The amounts
determined to be non-compensatory, that is, punitive payments, are NOT excludable.
….Product liability cases often include claims for personal physical and mental injury.
These cases will usually involve the various elements discussed above, relative to
compensatory damages for physical and mental injury, as well as punitive damages.
Proper allocation among the taxable and nontaxable portions must be determined.”

An Example of how Taxes Can Create Even More Emotional Distress

In a 2011 Tax Court Decision (McGowen v. Comm’r., T.C. Memo. 2011-186), the taxpayer sued
and claimed she was subjected to a hostile and offensive work environment by a co-worker who
actually threw a binder at her, even after reporting the incidents to her employer. Julie McGowen
suffered from emotional distress, taking a medical leave of absence and, after four months, was
fired. She sued claiming sexual harassment, failure to prevent sexual harassment, disability
discrimination, failure to prevent discrimination and intentional infliction of emotional distress.
She eventually settled with her employer who paid her legal fees of $39,750 and paid her
$42,625 for lost income and $42,625 for “physical injury caused by emotional distress.” The
past employer withheld taxes from the lost income and issued a W-2 for the lost income and
also issued a 1099-MISC for the emotional distress portion. She did not include the emotional
distress component in taxable income believing such damages were received because of

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personal physical injuries or physical sickness. The Tax Court found that the emotional distress
payment was taxable because there was no evidence of physical injury or suffering (i.e. the
binder did not physically injure her) other than from emotional distress, and, under the
settlement agreement, damages were not awarded because of physical injury or physical
sickness.
Other Tax Considerations Beyond Just Calling It "Income"

 For determining the reporting and withholding requirements in settlements and


judgments, it makes no difference whether the matter is concluded through an agreement
of the parties or proceeds to final court adjudication. Either way, awards for damages for
reportable personal injuries will be treated:

1. If applicable, withholding of employment taxes is required. Generally, both the


plaintiff and the defendant will prefer to treat such taxable awards as attributable to
non-wage claims. Otherwise the award will cause at least a 1.45% Medicare tax
liability to both the employee and the employer. Such awards up to the FICA cap
in the year received ($128,400 in 2018) may incur an additional 6.2% tax.
2. Form W-2 or Form 1099-MISC must be issued to the claimant
3. Payments for post judgment interest on both reportable personal injuries and for
non-reportable personal injuries must be reported on Form 1099-INT. A signed
copy of form W-9 must be obtained from the claimant and if the claimant refuses to
provide it, back-up withholding is required.
4. If a defendant fails to withhold taxes when required, the defendant may be liable
for the tax, which should have been withheld, plus interest and penalties. At a
minimum, defendants should consider the use of indemnification agreements,
escrow agreements, holdbacks or similar arrangements if they agree not to
withhold.

 The Appellate Courts have generally been split on whether contingent attorney fees paid
by a taxpayer are excludable from gross income. The IRS typically takes the position of
requiring the full amount of an award or settlement to be included in gross income. The
taxpayer was then generally entitled only to a miscellaneous itemized deduction for the

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contingent legal fee payment, the value of which was limited (often substantially) because
of the 2% threshold on miscellaneous itemized deductions, the phase out of deductions
for high income taxpayers and the non-deductibility of such fees for the alternative
minimum tax (AMT). Contrast this to only including in income that portion of an award
that is net of the contingent fee paid to the taxpayer's

Other Tax Considerations Beyond Just Calling It "Income (cont'd)

attorney. Prior to 2004 a majority of attorney’s fees were considered miscellaneous


itemized deductions subject limitations. Treating attorney’s fees as miscellaneous
itemized deductions had negative implications for taxpayers subject to the alternative
minimum tax (AMT), since attorney’s fees classified as miscellaneous itemized
deductions were not allowable as deductions for the AMT. After the enactment of the
American Jobs Creation Act of 2004, a new section created an above-the-line deduction
for attorneys’ fees and court costs incurred in employment claims and claims under
the federal False Claims Acts. Because the new deduction is “above-the-line”,
qualifying attorneys’ fees and court costs for these types of cases are no longer subject to
the reductions in itemized deductions and can be claimed for AMT purposes. The amount
that may be deducted above-the-line may not exceed the amount includible in the
taxpayer’s gross income for the taxable year because of a judgment or settlement. The
new section 62 defines “unlawful discrimination” to include several specific statutes, any
federal whistle-blower statute, and any federal, state, or local law “providing for the
enforcement of civil rights” or “regulating any aspect of the employment relationship…or
prohibiting the discharge of an employee, the discrimination against an employee, or any
other form of retaliation or reprisal against an employee for asserting rights or taking
other actions permitted by law.”

 The game has changed, once again, with passing of The Tax Cuts and Jobs Act. For tax
years beginning after December 31, 2017 and before January 1, 2026, the deduction for
“miscellaneous itemized deductions” that were subject to the 2% floor is suspended.
Ouch!

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 Lawsuit judgments or settlements have the identical tax rules apply (i.e. even if the case
only made it to correspondence between the parties). Attorneys will probably have
greater flexibility in minimizing income taxes with a settlement as opposed to an actual
lawsuit judgment.

 As alluded to earlier, structured settlements for physical injury awards where payments
are received over time rather than in a lump sum can escape taxation. If done properly, a

Other Tax Considerations Beyond Just Calling It "Income" (cont'd)

 structured settlement may convert "earnings" (i.e. imbedded interest factor) which
otherwise might have been taxable to tax-free.

 According to the IRS, if you receive a settlement for physical injuries or physical sickness
and took an itemized deduction for medical expenses related to the injury, the tax benefit
amount is taxable and should be reported as “other income” on line 21 of form 1040.

 You are best to trace the origin of a claim to determine the tax aspects. For example, if
an attorney was seeking for his/her client a recovery for lost profits from an ex-employee
starting a competing business, a settlement or award will be taxed as ordinary income for
such lost profits. If a client sues under whistle blower statutes, discrimination or another
wrongful discharge, such "wage replacement" will also be taxed as ordinary income.

 Similarly, if your real estate client sues a negligent contractor, a resulting award may not
be taxable income but, rather, a reduction in the cost basis of the underlying property.
The settlement over such basis may be treated as capital gain rather than ordinary
income. Once again, such rules can be very tricky and be reviewed with tax counsel or a
seasoned CPA.

 The IRS issued a memorandum (PMTA 2009-35) entitled "Income and Employment Tax
Consequences and Proper Reporting of Employment Related Judgments and
Settlements." While it boldly states that "…this advice may not be cited as precedent",

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the 20-page memo nicely lays out income and employment tax consequences and
required withholding for employment related judgments and settlements.

 Recipients of settlements and judgments generally worry more about the tax issues than
payors do. But a defendant preparing to pay a settlement or judgment should also find
the tax treatment of the payment to be important. A payment to resolve litigation should
involve one or more of: 1) an ordinary and necessary business expense deduction; 2) a
deduction as an investment expense; 3) a payment

Other Tax Considerations Beyond Just Calling It "Income" (cont'd)

 that is not deductible but must be capitalized as part of the cost of an asset; 4) a non-
deductible personal expense; or 5) a non-deductible fine or penalty. The Internal
Revenue Code does not expressly allow deductions for damages or settlement payments
but assuming the requisite business nexus, defendants deduct settlements or judgments,
including legal fees with little issue.

 We now generally have four “buckets” to place damages awards and related attorney
fees into:
1. Proceeds from awards excluded under section 104 (a)(2) because of physical
injury or physical sickness. (Deductibility of related legal fees will not be an issue
since the awards are tax-exempt anyway. Note that any punitive component is
taxable while the allocated legal fees and court costs are only deductible as
itemized deductions, with the inherent limitations)

2. Discrimination claims (i.e. employment related claims) where the proceeds are
reduced by the legal fees and court costs in arriving at Adjusted Gross Income...

3. Claims where only the net recovery/proceeds are reportable as gross income (i.e.
class action suit for securities, product liability, business practices, etc. Where
legal fees are paid directly from a qualified settlement fund. Only the net amount
is reported and includable in taxable income).

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4. Remaining claims not included in the above three categories. (The total gross
proceeds are included in taxable income while the related legal fees and court
costs may not even be taken as a “miscellaneous itemized deduction” after
January 1, 2018 and before December 31, 2025. This sorry bucket currently
leaves plaintiffs who do not qualify for an above-the-line deduction for their legal
fees will pay tax on 100% of their awards, not merely on the net amount they might
receive after paying their attorneys. Effectively, except for plaintiffs in employment
and some whistleblower cases will be precluded from deducting any of their legal
fees. Double ouch!
A New 2018 Twist – The Harvey Weinstein Tax Effect

The End to Deductions for Sexual Harassment Settlements Subject to a


Nondisclosure Agreement

We must tell you. Getting insight on the new tax law while enduring 82-degree weather in the
Bahamas was how to stay abreast. Clad in flip flops and an Abo and Company tee shirt, Marty
Abo read a legal advisory from friends at Fox Rothschild on one aspect we, candidly, did not
catch but know may affect many of our lawyer clients and colleagues and when we're brought in
to assist litigants. Thanks to Tiana R. Seymore, Esq., an employment lawyer in Fox Rothchild's
San Francisco office.

It's no secret that confidentiality agreements inspired outrage after reports that Hollywood mogul
Harvey Weinstein, former Fox News host Bill O'Reilly, NBC anchor Matt Lauer and a brigade of
celebrities and politicians paid millions of dollars in secret settlements to women who accused
them of sexual misconduct. Those settlements were subject to non-disclosure clauses that
would penalize the victims if they spoke out about their experiences

Effective January 1, 2018 sexual harassment or abuse settlements which include a


confidentiality agreement that prevents a victim from publicly sharing details about the incident
can't be deducted from taxable income as a business expense. The non-deductibility also
applies to attorney's fees related to such a settlement or payment. Note that the provision
doesn't apply to settlements that do NOT come with a confidentiality clause.

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As Tiana brought to our attention, while the original intent of this provision may have been to
keep corporations from deducting settlements of sexual harassment and sexual abuse
allegations from their taxes, the provision has far greater implications. Unfortunately, in current
form, the new law is not limited to businesses. It extends to individuals who receive settlement
payments, nixing their ability to deduct counsel fees. This results in double taxation and is
undoubtedly the result of the rush to enact the law before Congress took its Christmas break.

Yep, Marty was still in the Bahamas but he did check out the website of New Jersey's own
Senator Robert Menendez who initially introduced the amendment:
The End to Deductions for Sexual Harassment Settlements Subject to a
Nondisclosure Agreement (cont’d
"Corporations should not be allowed to write-off workplace sexual misconduct as a normal cost
of doing business when it is far from normal. That is why I was proud to offer an amendment to
the GOP tax bill that would both protect victims of sexual misconduct while ending the practice
of taxpayers subsidizing the bad behavior of corporations or executives. However, it has come
to my attention that when the final bill was written, language was inserted that does not reflect
my legislative intent, at best has led to confusion and, at worst, will inadvertently lead to sexual
misconduct victims being further victimized. This is outrageous and maddening, and what
inevitably can occur when members are forced to vote on haphazardly rushed legislation before
even getting a chance to read it."

Prior to 2018, victims who received settlements could deduct their legal fees from the settlement
so they didn't pay taxes on money they didn't receive, and their attorneys would pay taxes on
the money earned from the case. Since this new provision in the recent law eliminates that
deduction, those victims who now sign non-disclosure agreements must pay taxes on the entire
settlement, including the amount they pay to their attorneys. That amount would then be taxed
twice-once by the victim and again by their attorney. Yep, you read it right - the victim gets taxed
on the entire award - even the portion they don't get to keep.

Senator Menendez announced his intention to introduce legislation to fix the provision.

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Meanwhile, without a fix, employers and individuals faced with sexual abuse claims should know
of the need to structure settlements to address this issue.

The following 10 insightful and practical points were shared by my seasoned


tax attorney colleague, Steven Poulathas JD/LLM, shareholder at Flaster
Greenberg (steve.poulathas@flastergreenberg.com) at an earlier seminar I
was asked to deliver on tax aspects of damage awards to the trial lawyers of
the West Virginia Association for Justice.

Martin H. Abo, CPA/ABV/CVA/CFF


marty@aboandcompany.com

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10 PRACTICAL POINTS

#1 – You must know Tax Basics

Introduction – Tax 101

To thoroughly represent a client in a litigation matter, an attorney should maintain a


fundamental understanding of certain basic tax principles.

First, one must appreciate that different types of taxes are imposed on taxpayers:
income, employment, sales, estate, gift, excise, etc. More common than not the
types of taxes that arise in personal injury and employment controversies include
income and employment taxes.

Income taxes apply to ordinary income (i.e., wages, interest) or capital gains (sale
of a home, stock, company interests, real estate, etc.). Ordinary income is taxed
at progressive tax rates that currently range from 5% to 37%. Capital gains are
taxed at a preferential rate of generally 15% if the asset has been held for more
than one year. (20% for higher-income taxpayers) Clearly, one would prefer to
have a lower capital gains tax apply to a taxable recovery as compared to a higher
ordinary income rate. Even the “top tax rate” is elusive when you consider the
impact of a surcharge tax of 3.8% on Net Investment Income, the elimination of
exemptions and the limitation or elimination of common itemized deductions.

The amounts a party receives that are subject to income tax may also be subject
to employment taxes if they are considered wages. Wages cover almost
everything received by an employee from his/her employer with the exception of
certain specifically identified items. Employment taxes are generally split equally
between the employee and employer. Employment taxes for each employee and

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employer typically include 6.2% for Social Security on the base and unlimited for
the Medicare portion of 1.45% (plus an extra .09% applicable to higher income
earners).

Second, to better assist your client in negotiating a resolution to a controversy, you


must understand the strengths and weaknesses of the adversary. Accordingly,
one must appreciate the tax benefits and consequences for the other side. For
instance, assuming the other side is making a payment to your client, you will
have to determine whether the other party is tax neutral, tax advantaged or tax
disadvantaged by the payment. For starters, if the other side is paying wages,
they will have to pay employment taxes, but they also get a tax deduction. In
contrast, certain payments are deductible and are not subject to employment
taxes. In other cases involving penalties or punitive damages, the other side may
not be entitled to a deduction. Finally, in some cases, the other party may be a
non-profit or governmental entity that does not pay taxes and is completely tax
neutral.

Third, to the extent that your client receives a reward or damage, you want to
increase the net amount he/she can retain after paying attorney fees, taxes and
other costs or fees of the litigation. In this respect, you need to know what types
of recoveries are not subject to tax, and what legal fees or costs are deductible for
income tax purposes to increase the client’s net recovery. As if this were not
complex enough, there are two types of deductions, with one significantly
preferable to the other. An above-the-line deduction of legal fees affords a
taxpayer a deduction to other income without any limitations, caps or floors.
Before the Tax Cuts & Jobs Act of 2017 came along, a below-the-line deduction
afforded a taxpayer a deduction, but with limitations, caps and floors. For years
2018 through 2015, such legal fees and other “miscellaneous itemized deductions”
are no longer deductible.

Fourth, taxes may be applied at the federal, state and local level. Although there
is general consistency between what is taxable among jurisdictions that is not
always the case.

#2 You need to Consider the Origin of the Claim to Determine Tax Treatment

When preparing a demand letter, a complaint or a settlement agreement, the


practitioner must identify the origin of the claim to establish what the damages
represent for tax purposes. US v. Gilmore, 372 US 39 (1963). For instance, if one
was able to undo the wrongful act, what would the plaintiff receive? This is the
basis for the payment of damages.

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This is the method the IRS and the courts use to determine the tax treatment of a
payee’s recovery. The burden is on the taxpayer to be able to prove damages.

Example: In a reverse discrimination case that was audited by the IRS, the
taxpayer had to prove that a substantial portion of the recovery was for a claim of
physical injuries. The auditor could not imagine that one would be entitled to
physical injuries damages in a reverse discrimination case. Yet, a well
documented complaint and settlement agreement substantiated a claim for
physical injuries.

#3 When Drafting Your Complaint Use the IRC Claim Checklist to Make Sure You Have
Included Every Non-Taxable Claim

The Internal Revenue Code provides every practitioner a list of damages for claims that
would not trigger a tax recognition event.

Example – In a case for improper termination of an employee, who was recruited and had
to relocate to accept her job, the attorney made a claim for the loss of potential gain due
to a forced sale of the employee’s residence in a down economy. The IRC section 121
exclusion was able to shelter damages for lost gain on the sale of the principal residence.

[the claim checklist follows on the next page]

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Claim Checklist
Internal Revenue Code
Subtitle A Income Taxes – Subchapter B – Computation of Taxable Income
Part III ITEMS SPECIFICALLY EXCLUDED FROM GROSS INCOME §§101-140

§101 Certain death benefits.


§102 Gifts and inheritances.
§103 Interest on State and local bonds.
§104 Compensation for injuries or sickness.
§105 Amounts received under accident and health plans.
§106 Contributions by employer to accident and health plans.
§107 Rental value of parsonages.
§108 Income from discharge of indebtedness.
§109 Improvements by lessee on lessor's property.
§110 Qualified lessee construction allowances for short-term leases.
§111 Recovery of tax benefit items.
§112 Certain combat zone compensation of members of the Armed Forces.
§115 Income of states, municipalities, etc.
§117 Qualified scholarships.
§118 Contributions to the capital of a corporation.
§119 Meals or lodging furnished for the convenience of the employer.
§120 Amounts received under qualified group legal services plans.
§121 Exclusion of gain from sale of principal residence.
§122 Certain reduced uniformed services retirement pay.
§123 Amounts received under insurance contracts for certain living expenses.
§125 Cafeteria plans.
§126 Certain cost-sharing payments.
§127 Educational assistance programs.
§129 Dependent care assistance programs.
§130 Certain personal injury liability assignments.
§131 Certain foster care payments.

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§132 Certain fringe benefits.
§134 Certain military benefits.
§135 Income from United States savings bonds used to pay higher education tuition and
fees.
§136 Energy conservation subsidies provided by public utilities.
§137 Adoption assistance programs.
§138 Medicare Advantage MSA.
§139 Disaster relief payments.
§139A Federal subsidies for prescription drug plans.
§139B Benefits provided to volunteer firefighters and emergency medical responders.
§139C COBRA premium assistance.
§139D Indian Health Care Benefits.
§140 Cross references to other acts.

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#4– When Drafting A Complaint Consider, if Applicable, Including the
Causes of Action That Permit a Plaintiff to Deduct the Recovery of Attorney
Fees as an Above-the-Line Deduction.

Attorney Fee Checklist

Internal Revenue Code Section 62(a)(20)

Costs involving discrimination suits, etc. Any deduction allowable under this chapter for
attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any
action involving a claim of unlawful discrimination (as defined in subsection (e) ) or a
claim of a violation of subchapter III of chapter 37 of title 31, United States Code or a
claim made under section 1862(b)(3)(A) of the Social Security Act (42 U.S.C. 1395y(b)(3)
(A)). The preceding sentence shall not apply to any deduction in excess of the amount
includible in the taxpayer's gross income for the taxable year on account of a judgment or
settlement (whether by suit or agreement and whether as lump sum or periodic
payments) resulting from such claim.

Internal Revenue Code Section 62(e)

(e) Unlawful discrimination defined. For purposes of subsection (a)(20) , the term
“unlawful discrimination” means an act that is unlawful under any of the following:

(1) Section 302 of the Civil Rights Act of 1991 (2 U.S.C. 1202).

(2) Section 201, 202, 203, 204, 205, 206, or 207 of the Congressional Accountability Act
of 1995 (2 U.S.C.1311,1312,1313,1314,1315,1316,1317)

(3) The National Labor Relations Act (29 U.S.C. 151 et seq.).

(4) The Fair Labor Standards Act of 1938 (29 U.S.C. 201 et seq.).

(5) Section 4 or 15 of the Age Discrimination in Employment Act of 1967 (29 U.S.C. 623
or 633a ).

(6) Section 501 or 504 of the Rehabilitation Act of 1973 (29 U.S.C.791 or 794).
(7) Section 510 of the Employee Retirement Income Security Act of 1974 (29 U.S.C.
1140).

(8) Title IX of the Education Amendments of 1972 (20 U.S.C. 1681 et seq.).

(9) The Employee Polygraph Protection Act of 1988 (29 U.S.C. 2001 et seq.).

(10) The Worker Adjustment and Retraining Notification Act (29 U.S.C. 2102 et seq.).

(11) Section 105 of the Family and Medical Leave Act of 1993 (29 U.S.C. 2615).

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(12) Chapter 43 of title 38, United States Code (relating to employment and
reemployment rights of members of the uniformed services).

(13) Section 1977,1979, or1980 of the Revised Statutes (42 U.S.C. 1981,1983, or 1985).

(14) Section 703, 704, or 717 of the Civil Rights Act of 1964 (42 U.S.C. 2000e-2, 2000e-
3, or 2000e-16).

(15) Section 804, 805, 806, 808, or 818 of the Fair Housing Act (42 U.S.C. 3604, 3605,
3606, 3608, or 3617).

(16) Section 102, 202, 302, or 503 of the Americans with Disabilities Act of 1990 (42
U.S.C. 12112, 12132, 12182, or 12203).

(17) Any provision of Federal law (popularly known as whistleblower protection


provisions) prohibiting the discharge of an employee, the discrimination against an
employee, or any other form of retaliation or reprisal against an employee for asserting
rights or taking other actions permitted under Federal law.

(18) Any provision of Federal, State, or local law, or common law claims permitted under
Federal, State, or local law—

(i) providing for the enforcement of civil rights, or

(ii) regulating any aspect of the employment relationship, including claims for wages,
compensation, or benefits, or prohibiting the discharge of an employee, the discrimination
against an employee, or any other form of retaliation or reprisal against an employee for
asserting rights or taking other actions permitted by law.

Attorney Fees Analysis . . .

 If not within IRC section 62(a)(19). Prior to 2018, the tax treatment
afforded to attorney fees for causes of action not listed above was a
miscellaneous itemized deduction, which was subject to a floor of 2% of the
taxpayer’s adjusted gross income. In addition, itemized deductions were
sometimes subject to a phase out based on the taxpayer’s income and the
alternative minimum tax. Consequently, the chances for the taxpayer to
obtain any tax benefit could be significantly limited or even non-existent.
With passage of the Tax Cuts and Jobs Act effective January 1, 2018, the
deduction for such “miscellaneous itemized deductions” has been
eliminated.

Example: In a $1 million recovery, even under the lower tax structure of prior
tax law, where the attorney fees represent 1/3 of the proceeds, at an
effective tax rate of 45%, the plaintiff lost an additional $150,000.

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 Allocating Attorney Fees Among Multiple Claims. If there is more than
one claim in a complaint or in a settlement agreement, the attorney fees are
allocated among the claims proportionately and assume the tax character of
the claim to which they are allocated.

Example: $500,000 recovery split between claims of physical injuries and


emotional distress. $100,000 of the recovery is for attorney fees. Half of the
attorney fees are excluded from income consistent with the tax treatment of
physical injuries and the other half are taxable. Depending on whether the
claims for such damages were made under IRC section 62(a)(20), the
taxpayer may be able to deduct the $50,000 of taxable attorneys’ fees
above-the-line or lose them as a miscellaneous itemized deduction

 Attempts to Circumvent Taxation of Attorney Fees and IRS Position.


Attorneys and clients have used different mechanisms to attempt to avoid
the taxation of attorney fees, including transferring the right to the lawsuit to
attorneys and entering into joint ventures between the attorney and client.
These attempts tried to re-characterize the attorney fees into ordinary and
necessary business deductions as part of a business venture. Per
Bank/Benaitis v. Comm’r,543 US 426 (2006), the IRS may label such
attempts as an assignment of income, which requires the client to include
the amounts in income.

#5 – Do NOT Use a Boiler-Plate List of Claims or Damages in a Complaint or


Settlement Agreement.

The courts and the IRS will not respect an allocation to certain damages (e.g.,
non-taxable physical injuries) if there is no specific allocation to proven damages.
Courts have consistently criticized complaints that include a laundry list of claims.
Using such boiler-plate list of claims or damages in a settlement will cause any
intended allocation to be disregarded and permit the IRS to allocate damages to
items that are taxable. In a settlement, a third party should be able to read the
settlement and know without doubt what dollar amount has been allocated to each
type of damage.

In Ahmed, et ux v. Comm’r, T.C. Memo 2011-295,1 the petitioner’s complaint


discussed his physical injuries, but no claim for physical injury damages was
stated. Moreover, the court goes through an effort to state at least twice that “the
1 This is a case the IRS is currently citing in their audits to challenge a Taxpayer’s allocation in a
settlement.

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settlement agreement’s only mention of “personal injuries” was in boilerplate, and
that the record in the instance case contains no other evidence showing that any
part of the settlement was for personal injuries.”

#6 – Be Precise in Drafting Your Complaint and Settlement Agreement to


Reflect Statutory Exclusions.

Personal injuries are NOT the same thing as physical injuries. Be careful to avoid
subjecting your client’s recovery to taxation as a result of the use of improper
terminology. Make sure to reflect the exact language of the Internal Revenue
Code.

In Ahmed, et ux v. Comm’r, T.C. Memo 2011-295, the court notes in footnote 2 of


the opinion that personal injuries are not the same as physical injuries, which are
excluded under IRC section 104.

#7 –Make Sure Claims for Tax Excluded Items are Supported in the Trial Record by
Testimony, Evidence and the Payor’s Intent.

If your client claims physical injuries, make sure there is testimony and medical records
that substantiate such physical injuries. Moreover, in a settlement agreement make sure
that the payor’s intent is CLEAR that the damages are being made for physical injuries.
In Espinoza v. Comm’r, 636 F.3d 747 (5th Cir. 2011), the court looked to the origin of the
claims by examining the claims set forth in the complaint and in the settlement
agreement. The petitioner in Espinoza never claimed physical injuries or damages for
physical injuries in the complaint. Moreover, the settlement agreement in Espinoza was
silent as to what claims were being settled. Notwithstanding the absence of any claim for
physical injuries that could be excluded under IRC section 104, the court still reviewed
other evidence to permit the petitioner to substantiate why the damages should be
treated as a result of physical injuries and to establish evidence of the payor’s intent for
physical injuries. The petitioner in Espinoza simply did not have any such evidence.

#8– Make Sure the Payor’s Intent and Information Returns Are Consistent.

Make sure that Information Returns are prepared and filed consistent with intended tax
treatment of each claim and damage recovery. The IRS looks at the payor’s intent in its
review of the tax treatment afforded in settlement and may ignore the settlement terms if
the payor issues a Form W-2 or Form 1099 that is inconsistent with the intended tax
treatment provided for in the settlement.

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#9 – Consider Your Client’s Best Case and Worst Case Net Proceeds Before Commencing
Litigation.

Do not proceed or recommend litigation to a client who will have a negative return on his
or her investment in the litigation. It may be grounds for malpractice.

Example: Assume you are able to achieve a $350,000 settlement recovery for a
construction worker who witnessed his co-workers death and sued the manufacturer of a
faulty scaffold that caused the death. The settlement was allocated as $50,000 lost wage,
$100,000 emotional distress and $200,000 for attorney fees and costs. At an assumed
45% tax rate, the plaintiff will be out of pocket $11,325.

This example is rare, but has occurred several times.

One must also take into account the cost of defending a Taxpayer’s tax treatment if an
aggressive position is taken on a tax return.

#10 – Consult with a Tax Professional During Each Stage of a Controversy, Negotiation,
Litigation, or Arbitration Process.

Once a trial record is established and the parties have reached a settlement, a tax
professional has at least one hand tied behind his or her back to try to mitigate negative
tax implications.

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Martin H. Abo, CPA/ABV/CVA/CFF
marty@aboandcompany.com

Abo and Company, LLC


Abo Cipolla Financial Forensics, LLC

Certified Public Accountants / Litigation & Forensic Consultants


www.aboandcompany.com

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