The Catholic University of America

Q & A on Tax Obligations regarding Settlement Payments

Q: How is "gross income" defined in the Tax Code?

A: Section 61(a) defines "gross income" as "all income from whatever source derived." The general rule is that gross income is taxable.

Q: Does gross income include settlement payments?

A: Yes, gross income includes settlement payments subject to certain exemptions.

Q: Are there exceptions to the rule that as gross income, settlement payments are taxable?

A: Yes. Settlement payments are taxable wages if the settlement payments are pay for past or future services BUT settlement payments are not taxable if they are non-punitive damages received[1] for personal physical injuries or physical sickness.[2] Since 1996, emotional distress is not treated as a physical injury or physical sickness.

Q: Is the rule that only settlement payments for personal physical injuries or physical sickness are nontaxable a fixed rule?

A: No. Recent case law seems to suggest otherwise; courts have read a variety of factors (other than whether they are for physical injuries or sickness) as also influencing whether settlement payments are exempt from taxation. For instance, there does not need to be a strict employment relationship at the time of the litigation to trigger the tax withholding requirement. Moreover, if the settlement arises from a contract breach, the settlement payments received by former employees are taxable.

Q: Have there been any constitutional challenges to the rule that only payments for physical injuries are nontaxable?

A: Yes. The D.C. Circuit ruled just last year that, to the extent that damages for nonphysical injuries are taxable, the Sixteenth Amendment[3] of the U.S Constitution is violated. Therefore, damages resulting from emotional distress should not be taxed, contrary to the Tax Code. This rule is limited to D.C.

Q: Are attorneys' fees gross income?

A: Yes. The Tax Code does not specifically mention legal fees as gross income, and courts were split on this issue until recently. The Supreme Court (see Commissioner v. Banks 543 US 426 (2005)) resolved this issue by determining that attorneys' fees are gross income, even under a contingent fee arrangement.

Note that the American Jobs Creation Act of 2004 (section 703) amended the code to allow a taxpayer, in computing AGI to deduct "attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination." Referenced in Banks, supra in Section II, second paragraph.

Q: What should the university do if it pays the attorneys' fees directly to an attorney in a settlement case?

A: The university must file an information return if the fees exceed $600 per calendar year. See Reporting of Payments to Attorneys. See also the next question.

Q: What should the university do if it pays both the settlement and attorneys' fee in a joint check?

A: The school is required to file an information return reporting a payment to the plaintiff equal to the total of the two amounts. The same reporting rule applies if two separate checks are given to the plaintiff and the attorney(s). The following two examples demonstrate these rules:

Example 1: Attorney P represents client Q in a breach of contract action for lost profits against defendant R. R settles the case for $100,000 damages and $40,000 for attorney fees. Under applicable law, the full $140,000 is includible in Q's gross taxable income. R issues a check payable to P and Q in the amount of $140,000. R is required to make an information return reporting a payment to Q in the amount of $140,000. For the rules with respect to R's obligation to report the payment to P, see section 6045(f) and the regulations thereunder.

Example 2: Assume the same facts as in Example 1, except that R issues a check to Q for $100,000 and a separate check to P for $40,000. R is required to make an information return reporting a payment to Q in the amount of $140,000. For the rules with respect to R's obligation to report the payment to P, see section 6045(f) and the regulations thereunder.

Q: What should the university do if they are unsure what portion of the settlement check issued represents attorneys' fees?

A: In this case, the university must issue an information return for the entire amount to both the plaintiff and the attorney.

This Q and A was written by Rashmee Tadvalkar, OGC Legal Intern

[1] Whether by suit or agreement and whether as lump-sums or periodic payments.

[2] This exclusion is predicated on a conjunctive two-prong test: (1) whether the underlying claims are based on tort or tort-type rights and (2) damages are received because of personal physical injuries or physical sickness.

[3] The Sixteenth Amendment states that "The Congress shall have power to lay and collect taxes on incomes, from whatever source derived."

links updated 6/25/08 rab
Links checked July 7th, 2010, FJL.

updated 8/9/10 to add reference to exception for fees in discrimination cases, upon suggestion of Smruti Radkar, Assistant GC, UDC