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  • Writer's picturePaul Peter Nicolai

Avoiding Settlement Tax Errors

Updated: Feb 15, 2022

Here are some common tax fallacies involving settlements and why they are wrong.

Putting the money in a lawyer-client trust account isn’t taxable. It can’t be taxed until taken out of the trust account.

When settlement monies go into a lawyer’s trust account, it is treated for tax purposes as received by the lawyer and received by the client. It is actual receipt of fees to the lawyer and constructive receipt of the client’s share. If a case settles and funds are paid to the plaintiff’s lawyer’s trust account, both the client and the lawyer can be taxed.

The client can’t be taxed on money in the trust account. It isn’t received by the client until paid to the client.

Taxes can often precede actual physical receipt. The IRS says a lawyer is the agent of their client. Absent exceptional circumstances, the client is treated as receiving funds when the lawyer does. It can create problems when settlement funds arrive in late December, but the client’s check does not go out until January. It may be possible to treat the funds as January income. If push comes to shove, the IRS can say it was payment in December.

If a settlement agreement calls for payment in the future, the client has receipt now.

You can call for payment in the future in many ordinary circumstances without triggering taxes before the payment is made. Suppose a client agrees orally to settle a case in December but specifies in the settlement agreement that the money will be paid in January. Is the amount taxable in December or January? The answer is January.

The mere fact that the client could have agreed to take the settlement in December does not mean the client has constructive receipt. The client is free to condition the execution of a settlement agreement on payment later. The key will be what the settlement says before it is signed. If you sign the settlement agreement first and then ask for a delay in payment, you have constructive receipt.

They won’t issue a Form 1099

You never really know what IRS Forms 1099 will be issued unless the settlement agreement makes it clear. If a Form 1099 is issued in January, you usually will not convince the defendant to undo it without express tax language in the settlement agreement that negates a Form 1099. If the settlement agreement is not explicit, you are out of luck. Forms 1099 are issued for most legal settlements, except payments for personal physical injuries and capital recoveries.

The IRS can’t possibly tax the plaintiff on legal fees.

Both the client and the lawyer have to take legal fees into income. In 2005 the U.S. Supreme Court held that plaintiffs in contingent fee cases generally must recognize gross income equal to 100 percent of their recoveries. Even if the lawyer is paid separately by the defendant, and even if the plaintiff receives only the net settlement after legal fees, 100% of the money is treated as received by the plaintiff.

This harsh tax rule usually means that plaintiffs must determine how to deduct their legal fees. Of course, the legal fees are gross income to the lawyer, too. It may not seem fair, but this isn’t double taxation.

The defendant can’t issue a Form 1099 to the plaintiff for 100% of the settlement and issue another Form 1099 to the plaintiff’s lawyer for 100%.

Wrong. IRS regulations on Forms 1099 expressly say that defendants should usually issue two Forms 1099, each for 100% of the money when the defendant does not know exactly how much each is receiving. If the defendant gives a joint check to the lawyer and the client, the plaintiff will usually receive a Form 1099 for 100%, and so will the lawyer.

If a law firm receives an IRS Form 1099 for 100% of a settlement, the law firm must pay tax on 100%, even if it pays out 60% to the plaintiff.

No, the plaintiff law firm merely pays tax on its fee—40% in this example. The confusion centers on IRS Form 1099. Generally, amounts paid to a plaintiff’s attorney as legal fees are includable in the plaintiff’s income, even if paid directly to the plaintiff’s attorney by the defendant. For tax purposes, the plaintiff is considered to receive the gross award, including any portion to pay legal fees and costs.

The IRS rules for Form 1099 reporting bear this out. Under current Form 1099 reporting regulations, a defendant or other payer that issues a payment to a plaintiff and a lawyer must issue two Forms 1099. The lawyer should receive one Form 1099 for 100 percent of the money. The client should also receive a Form 1099, also for 100 percent.

A portion of the payment reported to the lawyer may be income. However, the amount could also be for a real estate closing or another client purpose. The IRS does not track amounts reported as gross proceeds paid to an attorney on Form 1099 in the way it treats “other income” on from 1099-MISC Box 3. Therefore, the lawyer reports whatever portion of the reported payment (if any) is income to the lawyer.

Damages for pain and suffering are tax-free.

“Pain and suffering” may mean something under state tort law. But this phrase doesn’t mean much in tax law. Far from being a helpful phrase for tax purposes, the IRS generally treats it as a code for emotional distress, which is insufficient for tax-free treatment. To be tax-free, compensatory damages must be for personal physical injuries or physical sickness,

Avoid ambiguous “pain and suffering” language in settlement agreements. Ideally, the defendant should pay on account of personal physical injuries, physical sickness, and emotional distress therefrom.

Emotional distress damages are not taxable.

This remains surprisingly prevalent, even though Congress amended section 104 of the tax code back in 1996 to state that emotional distress damages are taxable. Only if the emotional distress emanates from physical injuries or physical sickness are the damages tax-free. That’s why you might commonly see the phrase “physical injuries, physical sickness, and emotional distress therefrom” in settlement agreements.

That sounds simple, but precisely what injuries are “physical” turns out to be messy. If you make claims for emotional distress, your damages are taxable. If you claim that the defendant caused you to become physically sick, those damages should be tax-free. IF emotional distress causes you to be physically ill, that physical sickness will not mean tax-free damages. That is because the emotional distress came first; the illness is a byproduct of the emotional distress.

In contrast, if you are physically sick or physically injured, and your sickness or injury itself produces emotional distress, those emotional distress damages should be tax-free. These lines are hard to draw in the real world and sometimes seem contrived.

If you lose money or property and sue to recover it but don’t have a net gain, you can’t be taxed.

This fallacy sounds perfectly logical. How could you possibly be taxed if you lost something worth $1 million and only get back $500,000? Unfortunately, you can still be taxed even if you don’t break even in the case.

In investment loss and property damage or destruction cases, taxpayers need to consider their tax basis in the property, as well as its fair market value. Suppose you had a million-dollar stock portfolio that was churned by your investment adviser, dropping its value to $200,000. That sounds like an $800,000 loss, right? If you recover, say, $500,000, isn’t it clear that you can’t be taxed?

But we need to know your tax basis in the property. You hada $1M stock portfolio, and let’s say that you previously paid $1M for these investments. That was your tax basis and the fair market value of the investments. In that event, you still lost money, so you would probably use the $500,000 to reduce your tax basis in the assets. What if your tax basis in the $1M portfolio was only $100,000?

In other words, you had $900,000 in untaxed capital gain before the mismanagement. You lost money when your investment adviser mis stepped, but if you get back $500,000, with only a $100,000 tax basis, you have a big gain and taxes to pay. That is true even though you had a portfolio with a market value of $1M that was mismanaged, and even though you only got a portion of your money back.

The same thing happens with other property cases, such as wildfire cases and many others. Where there are taxes to pay, there may be section 1033 involuntary conversion benefits possible in some cases.

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