Tax Considerations are Key in Negotiating Settlement Agreements

Frequently, the tax ramifications of litigating or settling a legal case are not considered by the litigants and their attorneys until after the fact.  As a result, litigants and attorneys often miss a valuable opportunity to improve their tax position at the time of reaching a settlement agreement with respect to a given legal dispute.  In many instances, tax treatment will have a significant and direct impact on the finances of a client.  Therefore, it is important for the litigants to do a preliminary tax analysis with respect to a potential settlement of a litigation claim.  In this regard, a recovery pursuant to a settlement or award agreement will be much more attractive to a plaintiff if such an award is taxed at capital gains rates versus being taxed as ordinary income, or better yet, if the plaintiff can treat the amount recovered from the defendant as completely tax-free.  The tax considerations associated with a settlement or judgment are usually just as important to defendants as they are to plaintiffs since payments by a defendant pursuant to a settlement agreement may be fully tax deductible, partially deductible, or entirely non-deductible. Consequently, it is crucial that the parties to a litigation settlement understand the applicable tax rules and address the tax consequences of a potential settlement prior to resolving litigation.

Whether a recovery is on account of a jury award or due to an out-of-court settlement, the tax rules affecting settlements and judgments will apply.  Seeking assistance in this area early will increase the chance of structuring the tax impact to maximize the benefits to litigants.  There are several questions that need to be answered when making determinations about the taxation of judgment awards and settlements.
  1. What recoveries need to be reported and what portion of the recoveries will be treated as taxable to the plaintiff?
  2. What provisions should be included in the settlement agreement in order to clearly allocate the recovery amounts among various categories of damages?
  3. Will any portion of the recovery be treated as a capital in nature, giving rise to capitalization issues or possible long-term capital gains tax treatment?
  4. How will attorneys’ fees paid by plaintiff be treated for tax purposes?
  5. How will the payments pursuant to the settlement agreement be reported for tax purposes?
The answers to the above questions are vital in determining the federal income tax liabilities for each of the parties to a given settlement agreement.  Each of the above questions is discussed in further detail below.

General Rules Regarding Whether a Settlement Amount is Taxable

In terms of settlement and judgments, the most important exception to the general income inclusion provision is for personal physical injuries and physical sickness under Section 104.  Under Section 104, if funds are recovered on account of a personal physical injury or physical sickness then the recovery is excludable from gross income.  Conversely, damages received on account of non-physical injury or sickness (i.e. defamation, age discrimination, housing discrimination, injury to personal or business reputation, etc.) are not excludable from gross income.  Clearly, there is an incentive to posture a recovery so that it fits under the §104 umbrella.  Nonetheless, the most enduring cannon in this area is the “origin of the claim” test, which states that the tax result of a settlement or judgment award should be determined by reference to the underlying claim the lawsuit seeks to redress.  The origin of the claim test plays a crucial role in determining the tax treatment of payments received or made under a judgment or settlement.  The origin and nature of the underlying claim is examined to determine each of the following:
  1. Whether the payment is excludible from gross income;
  2. If the payment is not excludible, whether it is ordinary income or capital gain;
  3. Whether the payment is deductible as a trade or business expense or a production of income expense; and
  4. Whether the payment must be capitalized.
Thus, for example, a recovery for back pay is treated in the same manner as salary or wage payments and therefore taxable as ordinary income since the origin of the claim is payment by an employer for services rendered by an employee.

What Tax Provisions Should be Included in a Settlement Agreement?

Although various considerations will affect the  tax provisions that should be included in a settlement agreement, one principle is very clear:  it is not wise to use a general release with no allocation among damages since doing so will likely cause the IRS to allege an allocation different from the allocation that may have been intended by the litigants.  Taxpayers are much more likely to get into trouble with respect to the tax treatment of litigation recoveries if the settlement agreement is silent as to both the specific claims being addressed and the tax treatment of any recovery of each claim.  The taxpayer is the party that must bear the burden of proof to demonstrate what portion of the recovery constitutes a nontaxable or a capital item.   Therefore, it is important to consult a tax attorney who is familiar with the taxation of settlements and judgments so that necessary provisions can be negotiated and included in the settlement agreement in a manner that will maximize the taxpayer’s ability to treat the payments in a manner that will be respected for federal income tax purposes.

Will Any Portion of the Recovery be Treated as Capital In Nature?

In business recovery cases, the issue is generally not whether the amounts received pursuant to a judgment or a settlement are includible in gross income, but whether such amounts are characterized as ordinary income, return of capital, or capital gain.  If, upon examining the nature of the underlying claim, it is determined that the recovery is a substitute for lost profits, then such amounts are includible by the taxpayer as ordinary income.  However, if the recovery is on account of loss of goodwill or harm to other capital assets, then the amounts are characterized as capital gain, provided the sale or exchange requirement is met.  In some cases, an allocation between ordinary income and capital gain may be required.

Generally, a recovery which compensates solely for harm to capital assets results in capital gain or a reduction of capital loss depending upon the taxpayer’s basis in the capital asset and provided the sale or exchange requirement is met.  In some cases, the recovery may be attributable to both lost profits and harm to capital assets. In such cases, the taxpayer is required to allocate the amounts received to lost profits (i.e., ordinary income) and damage to capital assets (i.e., capital gains).  Note, however, that the burden is on the taxpayer to show that a recovery (in whole or in part) is attributable to harm to capital assets.  Therefore, it is important to consult a tax attorney who can make sure that it gets documented in the settlement agreement what portion of the settlement will be allocated to items that are arguably capital in nature and should therefore not give rise to the taxpayer reporting such amounts as ordinary income.

How Will Plaintiff’s Attorneys’ Fees be Treated for Tax Purposes?

It is typical in most plaintiff’s lawsuits for the claimant to request the reimbursement of attorneys’ fees and costs and for the plaintiff’s attorneys fees to be a contingency fee arrangement whereby the attorney will be paid a certain percentage of the plaintiff’s total recovery.  Accordingly, in settling lawsuits, companies may specifically designate an amount to be paid as attorneys’ fees.  These fees may be paid to the claimant, to the lawyer or to the claimant and lawyer jointly.  The taxation of attorneys’ fees has generated much controversy, but the general rule is that the payment of attorneys’ fees is taxable to the claimant regardless of the type of fee arrangement (i.e., flat fee, hourly or contingent) and even if the fees are not paid directly to the claimant.

As part of settlement negotiations, it is important for the claimant to understand whether the impact of including attorneys’ fees in the claimant’s income (as described above) may be mitigated in some cases because a specific code section permits an “above-the-line” deduction for attorneys’ fees incurred in connection with certain lawsuits.  However, there are various limits on deductions for attorneys’ fees, such as certain attorneys’ fees that are only deductible as “miscellaneous itemized deductions” limited by the 2%-of-adjusted-gross-income limit and attorneys’ fees that may not be deductible for AMT tax purposes.  Therefore, it is imperative that any plaintiff who is deciding whether to accept an award (pursuant to a negotiated settlement agreement) fully understand whether he or she will ultimately receive the benefit of any income tax deduction with respect to the plaintiff’s attorneys’ fees that will ultimately be deducted from the plaintiff’s final recovery.

How Will Payments Pursuant to the Settlement Agreement be Reported for Tax Purposes?

All payments in excess of $600 that are taxable to the claimant (including attorneys’ fees) must be reported on either a Form W-2 or Form 1099.  All taxable amounts are reportable to the claimant even if the payments are made to the claimant’s attorney.  However, if a claimant receives only amounts that are nontaxable, no information reporting to the claimant is required.

A) Form W-2 Reporting to Claimant

All payments attributable to wage-related claims must be reported on a Form W-2 issued to the claimant.  The defendant should issue a Form W-2 to the claimant for the total amount of all such payments, even if the check is issued directly to the claimant’s attorney (or to the attorney and the claimant jointly), and even if a separate Form 1099 is issued to the claimant’s attorney for some or all of the amount.  Only payments attributable to wage claims are reportable on Form W-2.  All other taxable payments are reportable on Form 1099. For example, both punitive damages and attorneys’ fees are reportable on Form 1099, not Form W-2.

B) Form 1099 Reporting to Claimant

All taxable nonwage payments, such as punitive damages, liquidated damages, compensatory damages, payments for emotional distress, interest and attorneys’ fees and legal costs associated with the recovery of taxable amounts, must be reported on a Form 1099 issued to the claimant.  Companies should issue a Form 1099 to the claimant for the total of all such payments, even if the check is issued directly to the claimant’s attorney (or to the attorney and the claimant jointly) and even if a separate Form 1099 is issued to the claimant’s attorney for some or all of the amount.  In summary, the total amount reported on the Form W-2 issued to the claimant and the total amount reported on the Form 1099 issued to the claimant should equal the total amount of payments taxable to the claimant.

C) Reporting Amounts Paid to Claimant’s Attorney

Once a company determines its reporting obligations to the claimant, the company must also determine its reporting obligations to the claimant’s attorney. Treas. Reg. § 1.6041- 1(a)(1)(iii) states that: a person who, in the course of a trade or business, pays $600 of taxable damages to a claimant by paying that amount to the claimant’s attorney is required to file an information return under Section 6041 with respect to the claimant, as well as another information return under Section 6045(f) with respect to the claimant’s attorney.  The company should therefore issue a Form 1099 to the attorney for the full amount of the check, whenever the check is written in a manner that gives the attorney the right to cash the check.  This applies even if the check is for more than just attorneys’ fees and even if the entire amount or some of the amount is not taxable to the claimant. In addition, these rules do not vary depending on the nature of the underlying lawsuit. Thus, if the attorney has the authority to cash the check, a Form 1099 must be issued to the attorney in the settlement of class action lawsuits, fee shifting cases, injunctive relief situations, and so forth.


As this article demonstrates, there are numerous tax considerations that can potentially be of vital importance to the litigants and other various parties involved in the settlement of a legal dispute or ongoing lawsuit.  While this article gives a high level summary of the overall tax considerations with respect to negotiating the provisions that should be included in a settlement agreement, it is highly advisable to have a qualified tax attorney review the provisions of a proposed settlement agreement and recommend potential changes with respect to tax sensitive items that may not be addressed in the original draft of a given settlement agreement.

For further information, please contact Coby Hyman, a tax attorney in Houston, Texas. Mr. Hyman specializes in advising clients on important tax issues to be considered in negotiating the terms of settlement agreements.  Mr. Hyman can be reached by phone at (972) 740-0161 or via email at