By Lawrence P. Schaefer |
Clients injured by illegal employment practices often ask whether the amount paid to them, whether by settlement or judgment, will be taxable, and if so, at what rate? My first response is that you should talk to a tax lawyer or other financial services professional. A professional opinion to be relied upon has to come from such an expert, and this caveat applies equally to the information conveyed in this blog. I then go on to describe to clients what I understand about how taxes should apply to damages in employment-related recoveries. This means I generally have to tell my clients that yes, the amount recovered by them will almost certainly be subject to taxation, although not all of it at the rate which applies to wage-income.
Settlement or Judgement
Recovery of wages, whether by settlement or judgment, is always to be issued and reported as W-2 wage income, with all appropriate deductions and the employer responsible for paying its share of FICA, FUTA and SUTA tax deductions. This equates to a tax of 6.2% for Social Security benefits (up to an annual cap which was $118,500 in 2015), a Medicare tax of 1.45% of income, and an additional 0.9% when that income exceeds $200,000, as well as unemployment insurance taxes at the state and federal levels (FUTA and SUTA). The only step a plaintiff can take in this area to potentially reduce these taxes is to adjust the exemptions listed on the W-4 Form previously filed with the employer, but this should be done very carefully and only with the assistance of a financial services professional.
Emotional Distress and Reputational Harm
Damages for emotional distress or for reputational harm, however, should not be considered W-2 wage income, and should generally be issued as non-wage income, with no deductions, and accompanied by IRS Form 1099. This portion of the award will be considered taxable income by the IRS, with a very limited exception described below, so I always advise my clients to plan accordingly.
Tax Exception: Physical Injury or Sickness
The limited exception when emotional distress compensation is not considered income is described in Internal Revenue Code (IRC) § 104(a)(2). When a payment is received for emotional distress “on account of physical injury or sickness,” this compensation can be shielded from any taxation, and payments made which qualify under this exception should not be accompanied by Form 1099. Since this exception was established in 1996 (and before that time all such compensation could generally be excluded from taxation), however, the IRS has taken an extremely restrictive view of when distress is “on account of physical injury or sickness.” This has come to be characterized as the “cuts and bruises” exception, which requires an actual physical manifestation of injury, and medical treatment for this injury, before the attendant emotional distress recovery can be treated as tax-free. Payment to compensate for emotional distress not manifested by this type of physical injury, even severe distress accompanied by a Diagnostic and Statistical Manual of Mental Disorders (DSM) diagnosis (such as depression, severe anxiety, etc.), will be considered by the IRS to be taxable 1099 income, although medical/psychological treatment costs can often be deducted from this income.
Reputational Damage
In a related area, payment for reputational damages are considered taxable income, whether received by settlement or judgment. See Lindsey v. Commissioner, 422 F.3d 684 (8th Cir. 2005).
Issuing payments for emotional distress/damage to reputation will be treated as 1099 income and not W-2 income, however, it is important for you to consider, as this will be paid with no deductions, and you will, at minimum, not have to pay FICA and FUTA taxes, saving around 8%, on average. Careful tax planning, however, will be required for you to avoid a surprise bill when tax filing occurs.
IRS Treatment of Attorney’s Fees
My clients also frequently ask about how attorneys’ fees are treated by the IRS, especially when the other side has paid the fees (whether by settlement or through a prevailing party fee award), and has, appropriately, issued my clients a Form 1099 for the amount of those fees, even though no such payment was ever received by the client. This can be a sensitive area, as the proper method for the client to treat this 1099 “income” is to deduct these fees above the line (as a dollar-for-dollar deduction from Adjusted Gross Income). Attorneys’ fees for discrimination, retaliation, and related advocacy can be deducted in this fashion, as stated in IRC §§ 62(a)(20). 62-(e). Therefore, the affected client suffers no adverse tax consequences from the issuance of Form 1099.
While I stress that all of the above advice needs to be confirmed by a tax lawyer or financial services professional, knowing how tax code regulations apply assists Schaefer Halleen lawyers in maximizing recoveries for our client, while minimizing tax consequences.
As one of the most recognized plaintiff’s lawyers nationwide, Larry Schaefer has earned the respect of judges and other lawyers for his thorough and aggressive client advocacy in negotiation and litigation. He concentrates his practice representing people who are injured through employment discrimination practices. Larry serves as the firm’s CEO and head of litigation.
