SETTLEMENT PLANNING
A major part of our practice is devoted to analyzing and planning the tax treatment of damages, whether awarded as part of a settlement or sought at the successful conclusion of trial.
Amounts paid on account of personal physical injuries or physical sickness are excludable from income under Internal Revenue Code ยง 104(a)(1). Where physical injuries are clearly involved such as in a auto accident, the application of this section to allow tax free treatment is almost never in question.
Where difficulty arises is usually in the context of other, less obvious circumstances. Black mold in a home is an example. But the majority of cases where settling plaintiffs are looking to exclude all or part of their settlements involve employment related actions.
Nuances and subtleties abound in this area. A few words in a settlement agreement, or missing from a settlement agreement can mean a difference of tens of thousands of dollars in income tax. For example, a common provision inserted in a settlement agreement is one providing compensation for "emotional distress."
These two words have been the downfall of many attempts at the tax-free treatment of damages because emotional distress, in and of itself is specifically prohibited from forming the basis for tax-free compensation. Yet again and again employment law attorneys, who as a rule treat tax issues as a minor diversion on the way to reaching a settlement, insert these words where they will do the most harm.
When we are approached by someone who wants to discuss the exclusion of all or part of an employment law settlement from income, we take of necessity a skeptical view. Because so few cases of this type qualify to begin with, we want to avoid any false hope. More often than not, there are no physical injuries or physical sickness involved and we advise the inquiring party we unfortunately cannot be of assistance.
Even where there is a basis for exclusion from income it is only the beginning of the battle. If the client has come to us after a settlement has been reached, then we are usually forced to adopt a defensive posture, and often we conclude even that is not possible.
Ideally, then, we should be consulted before a settlement is drafted. This is not to imply obtaining the optimal settlement language will be possible even with advance notice. Far from it. Most defense attorneys who work for employers know little or nothing about taxation, and are therefore very protective of their employer clients and will resist language desirable for our clients no matter how benign it may be where the employer is concerned. In any case, it is an uphill battle and we do our best to make the client aware of this institutional bias, again to avoid unrealistic expectations.
But despite these obstacles, we have been extremely successful in drafting settlement language sufficiently defensible to allow us to have successfully defended every IRS challenge to our client's positions on settlement issues.
Our fees are extremely reasonable for these services and come in two options. Clients may either pay our standard hourly rate of $400 or pay fees equal to 1.5 percent (1.5%) of the amount excluded from tax. The hourly fees come without any type of legal representation services while there would be an additional and identical 1.5% fee for all legal representation on the specific issue of the damages covered under our opinion up to but not including the commencement of litigation, if and only if an audit of the position should happen.
Contact Tim Kelly directly at tim@timkelly.com to discuss a damages case.
