Settlement: Tax Considerations

by Robert B. Fitzpatrick

“For fools rush in where angels fear to tread.”- Alexander Pope

THE INFORMATION CONTAINED HEREIN IS BASED UPON SOURCES BELIEVED TO BE ACCURATE AND RELIABLE – INCLUDING SECONDARY SOURCES. DILIGENT EFFORT WAS MADE TO ENSURE THE ACCURACY OF THESE MATERIALS, BUT THE AUTHOR ASSUMES NO RESPONSIBILITY FOR ANY READER’S RELIANCE ON THEM AND ENCOURAGES READERS TO VERIFY ALL ITEMS BY REVIEWING PRIMARY SOURCES WHERE APPROPRIATE AND BY USING TRADITIONAL LEGAL RESEARCH TECHNIQUES TO ENSURE THAT THE INFORMATION HAS NOT BEEN AFFECTED OR CHANGED BY RECENT DEVELOPMENTS. THIS PAPER MAY CONTAIN LINKS OR REFERENCES TO OTHER THIRD-PARTY RESOURCES. SUCH LINKS OR REFERENCES ARE FOR THE CONVENIENCE OF THE READER. THE AUTHOR DOES NOT RECOMMEND OR ENDORSE THE CONTENTS OF THESE RESOURCES.

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DISCLAIMER OF ALL LIABILITY AND RESPONSIBILITY

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Robert Brian Fitzpatrick is the principal in the boutique law firm of Robert B. Fitzpatrick PLLC in Washington, D.C., which represents clients in employment law matters in the federal and state courts of the District of Columbia, Maryland and Virginia. Mr. Fitzpatrick has concentrated his practice in employment law disputes for over forty years. He has been a member of the D.C. Bar since 1968. He is the father of three, and grandfather of three.

Robert B. Fitzpatrick

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MC 4

IRS Advice“Pots” to Think About

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IRS looks to the nature of the claims that were the genesis of the lawsuit.

Origin of the Claim Doctrine

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Income and Employment Tax Consequences and Proper Reporting of Employment-Related Judgments and Settlements, PMTA 2009-035

https://www.irs.gov/pub/lanoa/pmta2009-035.pdf

IRS Advice

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“Generally the IRS will not disturb the allocation if it is consistent with the substance of the settled claims” IRS Publication 4345 (available at: https://www.irs.gov/pub/irs-pdf/p4345.pdf)

Allocation

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§6721(a) and §6722(a) enhanced penalty for intentional disregard § 6721(e) and § 6722(e).

Reporting Requirements - Penalties

MC 9

Allocation“Pots” to Think About

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The so-called act, which is actually a section of the Job Protection Act provides eighteen categories of cases where the fee is to be reported by the claimant as income and then treated as an above-the-line deduction, that is, a complete wash.

Civil Rights Tax Fairness Act

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§62(e)(1)-(21) (1)TRADE AND BUSINESS DEDUCTIONS (2)CERTAIN TRADE AND BUSINESS DEDUCTIONS OF EMPLOYEES (3)LOSSES FROM SALE OR EXCHANGE OF PROPERTY (4)DEDUCTIONS ATTRIBUTABLE TO RENTS AND ROYALTIES (5)CERTAIN DEDUCTIONS OF LIFE TENANTS AND INCOME BENEFICIARIES OF PROPERTY (6)PENSION, PROFIT-SHARING, AND ANNUITY PLANS OF SELF-EMPLOYED INDIVIDUALS (7)RETIREMENT SAVINGS [(8)REPEALED.]  (9)PENALTIES FORFEITED BECAUSE OF PREMATURE WITHDRAWAL OF FUNDS FROM TIME SAVINGS

ACCOUNTS OR DEPOSITS (10)ALIMONY (11)REFORESTATION EXPENSES (12)CERTAIN REQUIRED REPAYMENTS OF SUPPLEMENTAL UNEMPLOYMENT COMPENSATION

BENEFITS (13)JURY DUTY PAY REMITTED TO EMPLOYER [(14)REPEALED.] (15)MOVING EXPENSES (16)ARCHER MSAS (17)INTEREST ON EDUCATION LOANS (18)HIGHER EDUCATION EXPENSES (19)HEALTH SAVINGS ACCOUNTS (20)COSTS INVOLVING DISCRIMINATION SUITS, ETC. (21)ATTORNEYS FEES RELATING TO AWARDS TO WHISTLEBLOWERS

Claims Covered

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Circuit split resolved in In re Quality Stores, 134 S. Ct. 1395 (2014), holding that severance pay is wages.

Severance Pay

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Courts are split.◦ Melanei v. Bd. of Higher Ed., 652 F. Supp. 43

(S.D.N.Y. 1987) aff’d 814 F.2d 653 (2d Cir. 1987) (wages)

◦ New Luge v. McCormick & Co., 157 F.3d 582 (8th Cir. 1988) (not wages).

IRS contends wages

Backpay in Refusal to Hire Case

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Circuit’s Split◦ Gerbee v. United States, 164 F.3d 1015, 1026 (6th

Cir. 1999) (wages)◦ Dotson v. United States, 87 F.3d 682, 689 (5th Cir.

1996) (not wages) IRS contends wages

Front Pay

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2013 IRS Memo POSTF-129928-13 (August 30, 2013) (Reporting requirements for attorneys’ fees paid pursuant to settlement agreement)

Attorneys’ Fees

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In Carr v. Fresenius Medical Care, Civ. No. 05-2228, 2006 U.S. Dist. LEXIS 29627 (E.D. Pa. May 16, 2006) (the court concluded that an award of damages under the FMLA is not subject to withholding by the employer under federal and state tax laws).

IRS May Disagree

FMLA Damages

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Employer can write off repaying single damages in any case as a business expense, however any payment that represents penalties or fines above the single damages is non-deductible.

Employer Write-Offs

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Type of InjuryWhere does it hurt?

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The statute excludes such payments regardless of whether they are based on a physical injury or not.

Workers’ Compensation Payments

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Rev. Rule 85-97, 1985-2 CB50, amplifying Rev. Rule 61-1, 1961 CB14

Personal Physical Injury Exclusion

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Does the physical injury need to be “observable”?

IRS Priv. Letter Ruling 00-04-1022 (October 13, 2000)

But see IRS Priv. Letter Ruling 13-11-006 (March 15, 2013) (IRS excluded where settlement indicated taxpayer suffered physical injuries of inter alia inhalation of smoke (not a visible physical injury)).

Physical Injury Exclusion

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Does the physical injury need to be “observable”? IRS Priv. Letter Ruling 00-04-1022 (October 13, 2000) But see IRS Priv. Letter Ruling 13-11-006 (March 15,

2013) (IRS excluded where settlement indicated taxpayer suffered physical injuries of inter alia inhalation of smoke (not a visible physical injury)).

“We believe that direct unwanted and uninvited physical contacts resulting in observable bodily harm such as bruises, cuts, swelling, and bleeding are personal physical injuries under §104(a)(2).” LTR 200041022 Doc TOC 2000 26382, 2000 TNT 201-10. (available at: https://www.irs.gov/pub/irs-wd/0041022.pdf)

Physical Injury Exclusion

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What about weight gain or loss?◦ Bulimia?◦ Ulcers?◦ Nervous disorders?◦ Hives?

Physical Injury Exclusion

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There is an open question as to whether the physical sickness exclusion is limited to sicknesses of the body or whether it also encompasses sicknesses of the mind.

Physical Sickness

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Small Business Job Protection Act of 1996 Revises Section 104 – No Longer Mere Personal Injuries; Rather, Personal Physical Injury or Physical Sickness

The statute states that emotional distress is not considered a physical injury or physical sickness.

Emotional Distress

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The Congressional Report on the statute states that emotional distress includes physical symptoms which may result from the emotional distress.

And thus the exclusion does not apply to symptoms like, for example, insomnia, headaches, or stomach disorders.

The exclusion from gross income applies to any damages received based on a claim of emotional distress that is attributable to a physical injury or physical sickness.

The Report states that the claim must have its origin in a physical injury or physical sickness.

Presumably, a battery, a physical touching that produces various physical harms could qualify.

Emotional Distress

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The Congressional Report on the statute states that emotional distress includes physical symptoms which may result from the emotional distress.

And thus the exclusion does not apply to symptoms like, for example, insomnia, headaches, or stomach disorders.

The exclusion from gross income applies to any damages received based on a claim of emotional distress that is attributable to a physical injury or physical sickness.

Emotional Distress

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Prejudgment interest is not excludable See, e.g. Chamberlin v. United States, 401

F.3d 335 (5th Cir. 2005); Razpad v. Commissioner, 154 F.3d 1 (1st Cir. 1998); Brabson v. United States, 73 F.3d 1040 (10th Cir. 1996) cert. denied 519 U.S. 1039 (1996).

Prejudgment Interest

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Taxability is dependent on whether the employee contributed, that is, paid premiums.

Taxability is pro-rata with that contribution.

LTD Benefits: Tax Consequences

MC 30

Problems with Physical v. Mental

InjuriesMore line-drawing exercises than “Connect-the-Dots”

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Is PTSD a physical injury or a physical sickness?

PTSD

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Domeny v. Commissioner, T.C. Memo 2010-9 (U.S. Tax Ct.) (available at: https://scholar.google.com/scholar_case?case=16185874565592490058)

Exacerbation of MS

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Parkinson v. Commissioner, T.C. Memo 2010-142 (U.S. Tax Ct.) (available at: https://scholar.google.com/scholar_case?case=11264089271104936695)

A Heart Attack

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Sanford v. Commissioner, T.C. Memo 2008-158, Doc. 2008-13911, 2008, TNT 122-11 (U.S. Tax Ct.) (available at: http://www.ustaxcourt.gov/InOpHistoric/sanford.TCM.WPD.pdf)

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Attorneys’ FeesSharing the wealth

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A 1099 is to be issued to the claimant/plaintiff, as well as the lawyer.

Under the Civil Rights Tax Fairness Act, the fees ought to qualify for an above-the-line deduction.

1099 Tax Reporting For Attorneys’ Fees

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Counsel needs to provide employer with Tax ID Number and a W-9

The agreement ideally should provide a sample 1099 with Box 14 checked.

Attorneys’ Fees – IRS Form 1099 (the lawyer’s 1099)

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Provide a W-4 Ideally, the agreement should have a

sample 1099 to the claimant with box 14 checked.

Attorneys’ Fees – IRS Form 1099 (the claimant’s 1099)

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Section 409ADon’t defer consideration of this issue

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26 U.S.C. § 409A - Inclusion in gross income of deferred compensation under nonqualified deferred compensation plans

https://www.law.cornell.edu/uscode/text/26/409A

Potentially substantial tax penalties for non-compliance.

Section 409A

MC 41

Section 409A IssuesGraphics from:http://www.morninginvestmentsct.com/

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Section 409A Issues

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Other Issues to Consider

Bits and Sundries

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Private Letter Ruling 155282-05 (June 23, 2006) (opt-out class action – attorneys’ fees are not includable in class members’ gross income)

Opt-Out Class Settlement

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Sinyard v. Commissioner, TC Memo 1998 – 364, aff’d 268 F.3d 756 (9th Cir. 2001) (an ADEA opt-in class settlement where class members had contingency fee agreements with class counsel, the attorneys’ fees were attributable as gross income to class members).

Opt-In Class Settlements

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Amos v. Commissioner, T.C. Memo 2003-329 Randall O. Sorrels & Neel Choudhury, “Avoiding

the Confidentiality Tax Bite”, Trial June 2016, 56-58 (available at: http://www.thefreelibrary.com/Avoiding+the+confidentiality+tax+bite%3A+the+proceeds+of+your+client's...-a0147568320)

Robin Frazer Clark, “Avoid the IRS on Confidentiality Provisions”, Trial Practice Corner (http://www.gatriallawyers.net/trial-practice-corner-avoid-the-irs-on-confidentiality-provision.html)

Confidentiality Clause; Tax Implications

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Tax Liens

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Medicare Secondary Payer

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Structured Settlements

MC 50

Forms and AmountsRun the numbers

MC 51

W-2

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Federal Insurance Contributions Act (§ 3101) FICA: Two Parts

◦ Old Age, Survivors, and Disability Income Tax (OASDI – Commonly Called the “Social Security Tax”)

◦ Hospital Insurance Tax (HI Tax)

FICA

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6.2%

OASDI Tax

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6.2% of employee’s wages up to $118,500.00

Employee and Employer portion each equal 6.2%

6.2%

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The Employee and Employer portion are each 1.45% of all wages.

There is no cap on this tax. § 3101(b)(1)

HI Tax

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6.0% of the first $7,000.00 paid as wages in a given tax year.

FUTA (Federal Unemployment Tax Act § 3301)

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Form 1099