The Taxability of Settlements: A Conversation with Robert Wood
This interview with Robert Wood is part of Jonathan Negretti’s Legal Beagle Podcast, which is available on the Negretti & Associates YouTube channel and on Anchor.fm. The following transcript has been edited for brevity and clarity.
At Negretti & Associates, from time to time we get asked about the taxability of someone’s settlement or award if their case goes on to trial and they have a positive outcome. The answer is a resounding “maybe and possibly.” Determining the taxability of settlements can be a little tricky. The answer depends on the claims made in the settled case and what eventually produced an award.
With questions in mind, I sought out one of the top experts in our country regarding the taxability of settlements and awards: Mr. Robert Wood of law firm Wood, LLP in San Francisco. Robert has been featured across the country by various media outlets. He is the author of the book Taxation of Damage Awards and Settlement Payments. He also has written articles in Forbes and served as a contributor on Fox News. He is probably one of the best people to go to to ask about this question that we often get asked by our clients.
Jonathan Negretti: I’ll ask this umbrella question: Why is it important to know about the taxability of settlements and awards?
Robert Wood: In general, any time that money changes hands — whether it’s a legal settlement or something else — there are potential tax issues. If a plaintiff is receiving an amount, obviously, they’re typically well aware of what the legal fees are, if it’s a contingent-fee case. But, when they’re looking at their net amount, it’s important to know if the net amount is before-tax, after-tax, or some of both. I’d say probably just about every plaintiff who’s getting money wants to know what the tax treatment is.
Jonathan Negretti: Let’s talk about that tax treatment. I know it has a lot to do with the “origin of the claim.” In fact, you reference this as an important thing that should be considered — or, at least, the IRS will consider it when looking at settlements and awards are taxed. What does it mean — origin of the claim?
Robert Wood: It’s kind of an annoying doctrine because it’s cited in all the cases and gets applied by courts and the IRS, but I don’t think it’s terribly easy to understand. It’s possible to come out different ways, depending on your viewpoint. It basically means, “What is the case all about? What are you trying to get? What are you trying to collect? What is your legal claim about?”
For example, if your employer shorted you and didn’t pay you wages that he or she owes you, it’s easy to see that the amount that you collect in the settlement is probably wages. It would probably be treated the way it would have been treated, had you gotten paid correctly in the first place. That’s the concept. But most legal disputes are really messy and full of different claims, so it’s not always as straightforward as I just suggested.
– Robert Wood, “Five Key IRS Rules on How Lawsuit Settlements Are Taxed” in Forbes, July 1, 2019
Jonathan Negretti: So, in that situation, in which someone were to get wages for monies owed to them, it makes sense to me that that would be taxed, because you would be taxed anyway.
What about a situation where someone is in a car crash, and they get a combination of things? They get money for medical bills. They get money for lost wages for the time that they’re out of work. And then they get money for pain and suffering. Looking at those three different categories, how could they be treated by the IRS?
Robert Wood: That’s a great example, because it sort of proves that what I just said is either not correct or at least subject to exceptions. The personal injury case, the auto accident case — any kind of physical injury case is a good example.
The plaintiff’s goal is not to pay tax on any of it. That’s probably realistic in that kind of a case. There is a Tax Code section — it’s one of the most important in this area — Section 104 of the Internal Revenue Code. It basically says if you get a recovery for physical injuries, physical sickness, or related emotional distress, then it’s tax-free.
The question you asked me about wages is good to circle back to here. As you said it, the victim of this crash — the plaintiff — gets one of the elements of damages: wage loss — money that he should have gotten because he was working and he couldn’t go to work because of the accident. In some ways, you think, Well, wait a minute, isn’t that taxable? It shouldn’t be taxable as wages because it’s really a substitute for the wages he would’ve gotten. But Section 104, this Tax Code section, basically says the origin of this claim is the auto accident. It’s true that somebody who has a very high-paying job probably gets a larger auto accident recovery than somebody who has a low-paying job. But that’s not treated as wages. If it’s all compensatory, not punitive damages, it should all be tax free in your example.
Jonathan Negretti: Why is there a difference between compensatory damages and punitive damages?
Robert Wood: It’s historical. There have been arguments about this for decades. It was finally resolved in 1995, when the Tax Code was amended to say that punitive damages are always taxed. There was also a Supreme Court case about the same time that said the same thing. So there’s no more debate. I don’t know if it’s fair or not, but the theory was that punitive damages, by definition, aren’t to compensate you.
If, in your car crash example, you got injured and you get money for all of those injuries, that’s compensatory, it’s tax-free. On the other hand, if you got a bunch more money for punitive damages — because the auto maker made a defective automobile and the jury wanted to punish the company — that’s taxable, because the Supreme Court and Congress said punitive damages are never to compensate somebody.
Of course, what this does, if you have a case that goes to jury, and you have a verdict, it makes punitive damages a lot more painful. And it encourages settlement, I think. There can be tricky issues when cases are settling on appeal.
Jonathan Negretti: Let’s go back. You said that if someone’s hiring an attorney on a contingency basis, there may be different taxable amounts there, I want to make sure I understand this because I’ve heard two different things.
Let’s say the total settlement is $100,000 and the attorney got paid 40 percent. So $40,000 comes right off the top. The taxable amount to the client is $60,000. I’ve heard other people say, “No, that’s not right. It’s the full $100,000.” What do you say in that situation, Robert?
Robert Wood: Every plaintiff wants to know about this. I’d say a lot of people think, probably correctly, that it’s sort of counterintuitive. It really depends on the type of case. There were disputes for many decades over how attorneys’ fees would be treated in contingency cases.
The Supreme Court decided this issue in 2005 in the case Commissioner v. Banks. The court said, in your example, that’s $100,000 payment to the client — even though the lawyer probably received the full settlement proceeds and then deducted his or her fee of $40,000 and sent 60% to the client. The client probably only sees $60,000 and certainly doesn’t want to be taxed on any more than the $60,000. But the Supreme Court said, as a general rule — there are questions about whether there are exceptions here — that’s $100,000 of income or receipt to the client.
That doesn’t mean the client has to pay tax. In fact, generally speaking, it’s possible for the client to deduct or offset somehow. But there’s great debate on that. And it matters what kind of case it is. It’s been harder to do that since 2018.
Jonathan Negretti: Could that create a situation where there’s almost double taxation going on? Let’s just say the client in that situation had $100,000 of income attributed to them. The attorney has to pay tax on the 40 percent.
Robert Wood: Yeah, absolutely. I get phone calls from angry clients or perspective clients and angry lawyers, and they say that — sometimes not as nicely as you just did! They say this is unconstitutional. It’s unbelievable. It’s double taxation. That’s absolutely right. I mean, it’s very common in the tax system for money to be taxed multiple times.
And so, if the $100,000 comes in — and it’s because of this Banks case — let’s assume it’s all taxable. It’s all gross income to the client. The lawyer has gross income on the $40,000. That $40,000 is taxed to two different people.
The goal, of course, is for the client to offset or deduct it somehow. Usually this is possible, but not always. Yes, it’s possible that the same money is taxed to two different people. But, so far, there’s been no case that actually says that’s unconstitutional and strikes [the case] down.
Jonathan Negretti: Can you talk to me a bit about this concept of allocating damages? This is something you talked about in your Forbes article and why that might be beneficial and helpful in a situation where tax could be problematic. Can you just kind of explain that a little bit more?
Robert Wood: One of the most important things in the tax treatment of settlements or judgements — by the way, the same rules apply, the origin of the claim doctrine that you asked me about, and really most of the other concepts we’ll talk about today are all equally applicable to settlements and judgments — from my viewpoint as a tax lawyer, settlements are always better because there’s always more flexibility.
[With judgments], you really don’t know what you’re going to get. You know what the jury verdict says, but you don’t know what kind of tax forms you’re going to get. Sometimes you don’t even know if the company is going to withhold taxes.
Settlements are better, in terms of shaping what you want. One of the points that you want to think about is dividing-up the income or dividing-up the payments. Very frequently, it might be multiple things.
In your auto accident example, you mentioned medical expenses. But let’s say it’s an employment dispute, where you have a bunch of discrimination claims — they paid you less, they treated you badly. Often, in employment cases, there’s some amount that’s wages that are subject to withholding and then there’s some amount that is on a Form 1099, meaning no taxes are taken out. It’s kind of emotional distress money, for example. That’s not wages.
Sometimes lawyers’ fees are paid separately. Sometimes in employment cases you’re asking for some money to be treated for personal physical sickness or physical injury. This happens a lot in sexual harassment cases, where someone is saying I shouldn’t have to pay tax at all on that amount. It’s good to try to iron that out at settlement time, if you can.
Jonathan Negretti: Do the provisions that end up in a settlement agreement create any sort of binding requirement that the IRS must follow? I almost feel silly asking this question, but I’ve been asked by clients, so that’s why I’m asking you.
Robert Wood: It’s not a silly question. When you’re entering into a settlement agreement, it’s a legal document. It’s certainly binding on the parties. If the employer, in that example, says, “We’re not going to issue a 1099 for this, or we’re going to withhold only on this $100,000 and not on that other $100,000,” that’s binding on the parties. But it does not bind the government, the IRS. It doesn’t bind the state tax authorities. But I’d still say it’s important and it gives you a leg up on your preferred tax treatment.
Jonathan Negretti: What we are seeing more and more recently are confidentiality agreements in settlement agreements between parties. There’s a mixed opinion between the plaintiff’s bar and the defense bar on whether there should be consideration paid for the confidentiality. What are your thoughts on that?
Robert Wood: I’d say that there’s been a lot of confusion over confidentiality provisions — or the tax treatment of them. First of all, in my long, many-decade career as a tax lawyer, I’ve seen a lot of settlement agreements. I don’t know that I’ve ever seen one that doesn’t have some kind of confidentiality provision. Sometimes they go on and talk about not publishing anything or not talking to the newspapers. Sometimes it’s quite explicit. But there’s always something that says it’s private — at least in my experience. I don’t think you need to have a separate dollar amount stated. Sometimes people do that.
I think a lot of the question on this came about because of an unfortunate tax case involving Dennis Rodman, called the Amos case. That was the name of the plaintiff. It was kind of a little PI case where there was a photographer named Amos, who Dennis Rodman kicked at a basketball game. The guy was kicked in the groin — at least, that’s what he alleged. The guy sued, and it settled for, as I recall, $200,000. And so, the settlement agreement said $100,000 for being kicked in the groin — that’s physical injury, it shouldn’t be taxed — and then $100,000 for confidentiality, because Dennis Rodman’s handlers wanted to make sure it wasn’t discussed.
Somehow, the IRS went after the $100,000 for confidentiality. There’s a tax case that says, “Well, that’s not for the being kicked in the groin. That’s taxable.” I think, ever since then, there’s been this fear that confidentiality is taxable. Sometimes people put in a really small dollar amount. You know, “I’m paying $500,000 to make the case go away and I’m also paying you know, $50 or $5,000 for confidentiality.” I think it’s kind of silly, to me. If it’s 100 percent a physical injury case, you just say everything’s confidential. I think the danger is if you start putting numbers. Some people want liquidated damages clauses. There’s no really easy answer. But I think that was the genesis of that whole line of worry.
Jonathan Negretti: I totally agree. In fact, that’s the case that is discussed most often when this comes up and whether there should be consideration — and what the tax implication would be of that consideration if there was some taxable event after that.
Robert Wood: Yeah. I’m only a tax lawyer, but when I’ve seen people do that, one thing I would say is, “Well, look, we’re only putting $50 for confidentiality because we only want to pay tax on $50.” But doesn’t that mean that somebody could just violate it and then say, “Here you go. Here’s your $50?
Jonathan Negretti: That’s a really good point. How strong is that confidentiality agreement if it was $50?
Robert Wood: Yeah.
Jonathan Negretti: When it comes to lawyers who do not have the tax expertise that you do, and they want to make sure they’re counseling their clients correctly — clients are coming to them asking them these questions and they want to get you to the right person or the right people … because I don’t want to say the wrong thing and put you in a situation where you’re upset with me a year from now, when you’re filing your taxes — what are your words of wisdom? How should that be handled? Now we’re speaking to our audience of attorneys. What kind of advice would you give them, to put people in the best position to get the proper advice about these taxable events?
Robert Wood: There’s no easy answer to that, unfortunately. I’ve been an expert witness in malpractice type cases. And, I think, on the plaintiff’s side, which is the place where you’d usually see this, lawyers are, as you just said, trying to help the client. I think it’s a slippery slope. Many people don’t want to say, “Look, if you mention the word tax, I can’t talk to you. Taxes are always important.”
I think, probably, the best advice is to tell the client to get tax advice. Try to connect them to someone. Of course, there’s, I suppose, potential referral liability. But saying, “Look, I’m not a tax person, this person is. You’re on your own, but I’ll try to cooperate any, in any way I can” — I think that’s never a bad result. I think what may be the worst mistake is a well-meaning one: to try to provide tax advice and then to do it incompetently. No matter how well-intentioned you are, that can obviously blow up in your face.
Jonathan Negretti: You mentioned emotional distress. I read a lot about this because I was confused myself on how this becomes taxable. Can you talk a little bit more about that? Forget about the origin of the claim being a car crash. Let’s just say emotional distress damages related to any other type of claim. Why would that be taxable? How does that become a red flag for people when it comes to a settlement involving emotional distress?
Robert Wood: Sure. There’s still lots of confusion from clients. But I’d say I get a fair number of queries from lawyers who seem surprised — who say things like, “We’re treating that as emotional distress, so that’s not taxable.” Of course, that statement is wrong, or at least incomplete. Some of it is historical.
Up until 1996 — this is another one of these important dates — Section 104, the Tax Code section I mentioned, said that money for personal injuries was tax-free. In 1996, Congress changed the statute to say personal physical injuries. Up until 1996, it was quite true that emotional distress money was non taxable. That is no longer true. I mean, it’s maddening. There really is still no definition in the Tax Code or from the IRS about exactly what “physical” means.
So, on the emotional distress point, when the Tax Code was changed in ’96, there is a famous committee report — you know, one of these big, thick reports — where Congress and the people writing the law said, “When we say physical, we don’t mean just. Emotional distress is physical. Even if you have physical symptoms like stomach aches, headaches, insomnia, those are emotional distress things. And we don’t think they’re physical.” That is actually in a footnote. That’s some important learning. But there’s still a lot of gray area about exactly what’s physical and what’s merely emotional.
Jonathan Negretti: When someone’s unpacking all of this, and let’s say they’re bringing a claim for all these different forms of damages, is this where getting a tax attorney involved to help them understand the allocation of damages or just understand why some of these may be taxable, some may not?
Robert Wood: It is. There are not taxes to be saved in every single case, but in most cases, there are. Back to the $100,000 legal fee issue [with the $40,000 contingency fee], sometimes it’s simply to make darn sure that someone knows whether it’s clear that the legal fees are deductible or not, and, if so, how deductible?
In terms of the, the physical injury exclusion, it’s almost always worth getting some advice.
Back to your malpractice question about what lawyers should do, I mean, most lawyers, I guess, will say, “Look, we’re not tax people. We can’t give you tax advice, but you should get some.” Some go a step further and say, “You know, here are three you could call.” And some go a step further than that and say, “Look, I can’t provide tax advice, but to make sure that you’re getting advice, I’m willing to pay for an hour of time with so and so.” I think that’s a little uncommon. But some people do it. In any case, making sure that the client knows to get ahead of it is smart.
Jonathan Negretti: I read this settlement taxability form. You won’t be able to see it on your screen, but it’s from the IRS Publication and it talks about the taxability of settlements. I’m sure you’ve seen it. One of the things I found very interesting, as it related to medical expenses, is whether or not there was itemized deduction taken. It makes sense to me, when I read through this, why that would be taxable or non taxable, depending on the deduction. But can you explain to our audience why that would be a factor to be considered as they look at their settlements?
Robert Wood: Sure. And I am familiar with that document. There’s an IRS publication that’s called [Lawsuits, Awards, and Settlements Audit Techniques Guide]. It’s essentially for IRS people about how they should audit this issue. It’s worth looking at. The IRS updates it periodically.
The issue you’re asking about, I guess, is something that I would lump into a tax doctrine called The Tax Benefit Rule. As the name suggests, it essentially means if you got a tax benefit for something, then that may get recaptured. If you’ve been deducting medical expenses, for example, on your tax return — and typically that means probably big medical expenses — and then you get reimbursed for those down the road at some point, some years later in a settlement, the IRS can look back at those prior tax returns and see that you deducted them. Even though, normally, this kind of thing wouldn’t be taxed, they’re going to recapture the tax benefit that you got from the past. That’s the concept.
Jonathan Negretti: Gotcha. There is a section in the same publication that may put some of our listeners to sleep, but I think this is fascinating and I wanted to explore it with you. It’s talking about loss and value of property — and we’re getting into basis points. We often bring what are called diminished value claims on behalf of clients, and this is a situation where a client’s vehicle gets damaged. It isn’t a total loss, but now the vehicle is worth less than it was worth at the time of the crash. The taxability of this comes into play. Can you explain just maybe in a lay person’s way how adjusted basis works and why this needs to be important when someone recaptures a loss in value on their property?
Robert Wood: Sure. I mean, it’s a great point. It is a little confusing — or it can it be. And it comes up in a variety of types of cases. Essentially, for example, investment loss type cases, where you had a brokerage account and had $500,000 in it, and the broker mismanaged it or something, and it’s now down to $200,000, you get some of that money back. It’s kind of your own money. Is there some tax on that? The answer would be, “It kind of depends.”
For example, [to] the concept you just raised, Jonathan, is your basis $500,000, or was your basis $0, meaning you hadn’t paid tax on any of this, and you get some money back. You need to know things like basis. Just to use your example, if you have a basis of $50,000 that you paid for your car, it’s damaged and it’s now worth $20,000 and you get a settlement — they’re going to give you $10,000 toward your car — I would say your basis was $50,000 and now it just went down to $40,000, because you’ve got a payment that you could treat as income. I think it would be fair in that example to say it’s not really income because it’s just a recovery of some of my basis in my car — the $50,000 I originally spent.
That same concept applies in a lot of other kinds of property cases, like construction defect cases. You know, “I had you build this house for me. It’s now defective in certain ways. I paid X for it. It’s now worth less than X. I want to get reimbursed.” And most people wouldn’t want to have to treat that as income.
Jonathan Negretti: I’m going to ask you an off the wall question, because I got asked this and I have to know, from your perspective, what you think. This client and I — we were trying to prove up wages and wage loss. The defense attorneys wanted to look at tax returns. The client said, “If Trump doesn’t have to disclose his tax returns, neither do I.” I understand from a perspective of we have the burden, we have to prove that, but forget that for a minute. Robert, what is your thought on the confidentiality or privacy as it relates to tax returns? And I’m not talking about Trump now. I’m just talking in general about people saying, “My tax returns are private, I don’t have to share those.” What, what are your thoughts there?
Robert Wood: I think your client’s right. I mean, there are fights. I would say in cases that I’m advising on — or in some cases that I’m an expert witness on, which may not be a malpractice case, it may be some kind of contract dispute, where there are tax issues that I’m supposed to address — a lot of times, as a lawyer, if I’m involved in a case, I would say things like, “Gee, do you, do we have tax returns?” Because they always tell you something.
A majority of the time, at least in my experience, defendants can’t get plaintiff’s tax returns, precisely because of privacy. I suppose Trump probably helped that effort, as you say, because more than a few people would say, “Heck, if Trump doesn’t have to do it, I don’t either.” Very frequently when I have seen them in cases, they’ve been heavily redacted. This really isn’t the tax point, but my understanding is if the plaintiff has directly put an issue in sort of controversy, for example, that the tax return is the best evidence of that, then they can be fair game in some redacted portion or form. I think that’s my answer, at least.
Contact Negretti & Associates with Questions
Negretti & Associates is licensed to practice personal injury law in Arizona, California, and Colorado. Have a question about the taxability of settlements? For a free consultation regarding your case, contact us online, call us at 1-833-827-3535, or send us a text.
