'ff:#,%g*;:'" EMPLOYMENT LAW SBTTLEMENTS, AGREBMENTS AND RBLEASES ICLB SEMINAR EMPLOYMENT LAW FOR THE GENERAL PRACTITIONBR AND THE PROS

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1 EMPLOYMENT LAW SBTTLEMENTS, AGREBMENTS AND RBLEASES ICLB SEMINAR EMPLOYMENT LAW FOR THE GENERAL PRACTITIONBR AND THE PROS 'ff:#,%g*;:'" SePtember 25,2008 Presented by: Jack Rosenberg Attorney-Mediator Labor & Employment/Discrimination Law Unemployment APPeals Suite 380, One Overton Park 3625 Cumberland Boulevard Atlanta, GA F: j a c krose n ber a i l.co m

2 1. As a general proposition, yes. More specifically, it depends on how you allocate the settlerient amongthe various types of damages. The following table shows the different types of damages and whether they are taxable as income to the client: Tvpe of Damaqe Lost wages/back PaY and front pay Compensatory damages for emotional distress, Pain and suffering (NOT associated with Personal physical injury and NOT including medical expenses from emotional distress) Compensatory damages for emotional distress, Pain, and suffering (associated with Personal physical injury) Medical expenses associated with emotional distress Punitive damages EVEN IF ASSOCIATED WITH PHYSICAL INJURY Damages arising from a personal physical injury or sickness Liquidatedamages (such as FLSA, FMLA, ADEA) Attorneys' fees and costs of suit associated with em PloYment discrimination claims Taxable to the Client as Income! Yes Yes No No Yes No Yes No Who Savs?' 26USC.$104(a)(2); Commissioner v. Schleier, 515 u.s. 323 (1995). 26 U.S.C (a)(2) 26 U S C $ 104(a)(2) 26 U.S.C. $ 104(aX2) 26 U.S.c. $ 104(aX2) 26 U.S.c. $ 104(a)(2) Commissioner v. Schleier, 515 U.S. 323 (1995) (where liquidated damages are Punitive in nature, they are taxable under 26 U.S.C. $ 104(aX2)). 26 U.S.c. S 62(aX20); (e) (this is the first CRTRA) I IRS Publication 525 also provides useful information on what is, and is not' taxable income' Pase 1 of l0

3 2. amounts in the settlement agreement? Even though all of the components of a settlement may be taxable, the way they are reported to InS can vary, depending on the client's circumstances' The way an amount is reported then determines how taxes must be paid, and in what amount. Allocation is a good way to minimize, as much as possible, your client's tax burden. Allocating the payments in the settlement agreement may also help your client if, for,or. l".uion, the IRS conducts an audit and tries to challenge the way the client has treated the settlement fortax purposes. lf there is no allocation in the agreement, then the IRS is more likely to try to treat all of the settlement as taxable. When a settlement expressly allocates the settlement proceeds among various types of damages, the allocation is generally binding fbr tax purposes, as long as the agreement is entered into by the parties in an adversarial context; at aim's length; and in good faith'2 An express allocation will be disregarded only where the facts and circumstances,u.rounding the payment indicate that the payment was intended to be for a diffbrent purpose. If the settlement agreement contains an express allocation of-the scttlement proceeds, and the allocation is colorable in light of the claims in thc Complaint, then it is morc likely to be respected and followed. 3. each have? Basically, you have two choices: Form w-2 and Form 1099-MISC.] Within Form Mlsc, you have two further choices: Box 3 or Box 7. Box 3 is for "other income," including taxable damagc awards. Box 7 is for "non-employee compensation" over s600. Say, fbr example, you settle your client's case for $100,000. Your fee is $40,000' Ofthe remaining $60,000, you alloiate $20,000 to wage loss and 540,000 to emotional distress', 8.g., Bagtey v. Commissioner, 105 T.C.396,406 (1995), aff'cl 121 F.3d 393 (8th Cir' 1997); Robinson v' Commissioner, 102 T.C. l16, 127 (1994), alj'd in part, rel"d in parr and remanded on other grounds 70 F'3d 34 (5thcir. 1995);'t-hrelkelclv.()ommissioner,87T.C.l2g4,l (1986),a//'dsa8F'2d81(6thcir'1988)' t A copy of the 1099-MISC is attached to these materials. see also Instructions for Form 1099-MISC' Pase 2 of l0

4 Here's how you could have each amount repofted: 1. For the waqe loss portion: choose between W-2 or 1099/Box 7 you really should make this choice with the advice of your client's accountant or tax advisor. This decision can depend greatly on the client's financial circumstances. a. If you choose W-2: the Defendant will treat the payment as if it were a payroll check, and will deduct applicable taxes and withholding for Social Security and Medicare (FICA taxes). The Defendant will also have to remit the matching taxes, which represents 7 '65%' In this scenario, your client will receive a check for an amounthat is less than the $20,000, and will receive aw-2 at the end of the year. b. If you choose Form 1099-MISC. Box 7: the Defendant will cut a check to your client in the f'ull amount o1'$20,000. The Def-endant will not deduct any state, federal, or FICA taxes from this payment, and it will not remit any matching F'ICA taxes. At the end of the year, your clicnt will receive a 1099 with $20,000 reported in Box 7' Under this scenario, it is as if your client had worked fbr the Defendant as an independcnt contractor or was self.-employed. This means that your client will be on the hook for all of the taxes. This includes the employcr's i.65yo match with respect to the FICA taxes, as well as state and federal income taxes' which were not withheld' In general, the downside of this option is that the taxes are not withheld up front, which could impose dilficutty for clients who are not in a position to pay taxes (such as folks who count on a tax refund each year). Another downside is that the olient has to pay the employer's portion of the FICA taxes, as well as the employee portion, so the client may actually end up paying more taxes, even though it appears that she receives more of the $20,000 up front. Z. For the emotional-distress damases portion: The only choice here is to have this portion of the settlement paid via a separate check and reported in Box 3 of Form 1099-MISC. This box is for "other income" and is specifically designed for taxable damage awards. In short, you don't want a situation where your client is paying employment-type taxes on the portion of her settlement that is not wages. Be sure to specify in the settlement agreement that this payment is to be reported in Box 3 of the Form 1099-MISC. If the settlement agreement says only that this payment should be reported on 1099, the Defendant may mistakenly report it in Box 7, resulting in self-employment taxes to your client' Page 3 of l0

5 4. client is a Keep in mind that employees are not on the hook for Social Security taxes on amounts over $98,600. This means that, if a client earns $100,000 per year' she pays Social Security taxes on the first $98,600 of her salary. There is no ceiling for Medicare taxes, however, so she pays Medicare taxes on the entire $ Say, for example, your client becomes re-employed earning S120,000 ayear. You settle his age-discrimination case with his former employer for $100,000, of which $40,000 is yuu. f"". Of the remaining $60,000, you allocate $20,000 to wage loss and $40,000 to liquidatedamages. This may be a situation where it would be better to have the $20,000 reported on Form 1099/Box 7. This is because none of the $20,000 allocated to wage loss should be subjecto Social Security taxes; only Medicare. The fbrmer employer issuing the W-2 mat mistakenly deduct Social Security taxes fiom this amount, resulting in an overpayment. While the client may get a ref.und ultimately, he might as well keep the money, not thc IRS! If the client had received a 1099 instead, he would not pay any FICA taxes associated with Social Security because he is already above the $98,600 threshold Ibr those taxes via his current job. He would only be responsiblc fbr his portion, and the employer's portion, of the Medicare taxes, which is a relatively small amount. Keep in mind that the client would still be subjecto state and federal income taxes on this amount. Hc.f ust gets a break on Social Security taxes. What if there is an insurance carrier on the other side? Because your client was not employed by thc insurance company, it is not in a position to issue a W-2 to your client for any settlement amounts that you allocate to wage loss and that it ultimately pays out to your client. In this situation, if it would be better for your client to have a W-2, you should allocate as little as possible to wage loss. You could also take advantage of the deductible or retention amount, if it is important forthe cliento receive aw-2. In this scenario, if the deductible is $25,000, you could consider allocating that amounto wage loss so that the employer-defendant will rnake that payment and can then issue the W-2. You could also consider asking the defendant-employer itself to pay the wage-loss amount of the settlement so that the client mav receive a W-2 for it. I once was in a situation where an insurance carrier did not want any language in the settlement agreement about reporting the payments, and apparently did not want to repoft the paymenti to tns in any form, 1099 or otherwise. I found this very odd, but I still incorporated allocations into the agreement. Page4ofl0

6 6. Now that I've fisured out how to allocale,arl-d-epor! ment amoun manv checks should I have the Defendant cut. and how should mv fee be redorted? The IRS recently issued regulations about reporting payments made to attorneys. The regulationsimplify the rules about when a payor (such as a defendant-employer paying a settlement) has to report a payment made to an attomey. Now, all payments to attorneys must be reported, even where the attorney did not provide legal services to the payor. What this means for us is that we should think about how settlement checks should be issued: jointly to ourselves and our clients, or via separate checks to our clients and ourselves. Consider these examples from the regulations:a A. e check. made out ioint. example settlemen Client sues Employer. Employer and Client settle the case for $300,000. Settlement is taxable to Client. Employer writes one check to attorney for $200,000, representing the net amount of the settlement after income and FICA withholding. Attorney retains $100,000 of the payment as fees, and disburses S100,000 to Client. Employer must file an information return with respect to Attorney in the amount of $200,000. Employer must also file an inlbrmation return with respect to Client in the amount of s B. One made out ioint mole whe tlement not tax Client: Same example as above, but settlement is not taxable to Client because it is fbr personal physical injuries. Employer writes check payable jointly to Client and Attorney, and delivers the check to Attorney. Attorncy keeps $120,000 for fees, and disburses $180,000 to Client. Employer must file an information return with respecto Attorney for $300,000. Employer does not file any infbrmation return with respect to Client because damages are tax-free. C. Separate checks. settlement taxable to Client: Client sues L'mployer for discrimination; suit is settled for $300,000. Settlement is taxable to Client. Attorney has Employer write two checks, one to Attorney for $100,000 as fees, and one to Client in the amount of $200,000. Employer flles an informational report as to Attorney for $100,000. Employer files an information return with respect to Client fbr $300,000. The moral of the story here is that, if you have the Def-endant-employer issue one check made out jointly to you and your client, you will receive a 1099 showing the entire amount of the check, even though you disbursed part (most) of it to your client' o Taken ffom 26 C.F.R. $ Page 5 of l0

7 If you prefer to receive a 1099 from the Defendant in the actual amount of the attorney fee, then you should have separate checks cut. Because Defendants are now sending us 1099s, I keep a filled-out Form W-9 on hand to provide with the signed settlement agreement. Form W-9 is a request for taxpayer ID number, and you use it to provide the payor with your Social Security Number, or the TIN of your firm. 7. mv client's case the 1099 that included the emotional distress amount and the attornev fee. What happened? For example, say you settle<l your client's case for $100,000, of which $40,000 is your fee. 520,000 was allocated to wage loss, and was reported on W-2. $40,000 was allocated to emotional distress, with no physical injury. '['he employer issued a 1099 with ${t0,000 reported in Box 3. Your client has to report the entire $80,000 as income. But, she will then receive an "above-the-line" adjustment for the $40,000 that represents the attorney fee' On Form 1040, line 36 is for "write-in" adjustments. There is a dotted line on which the client will write in the $40,000 ancl the letters "tjf)c."s 'l'he effcct of this is that her adjusted gross income (which is ligured before standardized deductions are taken) will not include the attorney fee, and she will not pay any taxes on it. Keep in mind that this procedure applies only to attorney fees associated with what the IRS defines as "unlawful discrimination claims." The definition of what kinds of cases are covered is contained in 26 U.S.C. $ 62(e).6 This Code section is actually very broad and covers a wide spectrum of federal claims, and even state claims, including publicpolicy claims. That said, if you have a tort claim, such as defamation or tortious interference with something other than the employment relationship, I believe it would be difficult to characterize those claims as falling under the definitions in $ 62(e). Thus, contingent fees from these types of cases would be taxable as income both to you and to your client. This is because of the Supreme Coutt's decision in Banks. ln Banksv. Commissioner,543 U.S. 426 (2005), the Supreme Court held that attorneys' fees are taxable as income to the client, as well as the attorney. The Supreme Court's decision reverses the favorable rule in the Sixth Circuit under the lower court decision in Banks, as well as Estate oj'clarks ex rel. Brisco-Whittier v. United States,202 F.3d 854 (6th Cir. 2000). In these cases, the Sixth Circuit did not require a taxpayer to include the contingent-fee portion of a settlement in his or her gross income. 5,See Instructions to Form 1040 and Form 1040 itself. u This definition is at the back of these materials. Page 6 of l0

8 8. eoine on??!! The Civil Rights Tax Relief Act of 2007 is in the works and will eliminate taxes on compensato.y du-ug"t in suits relating to "unlawful discrimination," and will allow for income averaging foi backpay and front pay awards received (don't ask me abouthis!). According to the text of the H.R' 1540: Gross income does not include amounts received by a claimant (whether by suit or agreement and whether as lump sums or periodic payment) on account of a claim of unlawful discrimination (as defined by section 62(e)). Back pay and fiont pay awards remain taxable under the new legislation, as do punitive damages. As of this writing, both the House and Senate have pending bills, which have broad bipartisan rponrorrhip, and have been ref'erred to committee. 'l'he Senate legislation is S' losg, und is identical to the House version. Both versions of the legislation remain in committee. As for Murphy, on July 3,2007, the D.c. circuit reversed the decision it previously rendered on August 22, This case involved a claim for damages associated with loss of reputation and emotional distress. Murphy reached a settlement, and paid taxes on the award. She later sought a refund. Thc D.c. circuit originally held that, although these damages are "income" under Section 104(a)(2), taxing them was unconstitutional under the Sixteenth Amendment. Although the IRS petitioned for rehearing en banc,the original panel sua sponte vacated its decision and set a ncw schedule for briefing and oral argument. In the July 3rd decision, the Court of Appeals reversed course and held that emotional distress damages are, indeed, income thai is subjecto tax, where they are not associated with a physical injury So we're back to square one with this issue, and must wait for the purrug. of tn. Cnfifn. Murphy flled a petition for certiorari on December 13,2007. The Respondent has until March 17,2008,to file its response' The docket number is , if you want to monitor progress on the Supreme Court's website' 7 See Murphy v. lnternal Revenue Service,493 F.3d 170 (D.C. Cir.2007), rev'g 460 F'3d 79 (D'C' Cir' 2006)' See also GJ Stillson MacDonnell & william Hays weissman, D.C. Circuit Reverses Course and Finds Emotional Distress Damages are Subject to [ncome Tat, avallable at t-rttp;//www-,llttlglpo-nn. This was published as an e- newsletter specific to employment taxes. Paee 7 of l0

9 The bottom line is that, for now, you should treat emotional distress damages associated with non-physical injuries as taxable damages. Right now, it is not clear whether the Supreme Court will hear the Murphy case, or render a favorable decision if it does, and it is not clear when (or if) the CRTRA will be passed, or when it would become effective, assuming it passes. The current language of the legislation makes it effective for settlements after December 31,2006, but given the amount of time that has passed since it was first introduced (March 15,2007), this effective date may be changed. I plan to take a "business as usual" approach for now, and treat settlement amounts allocated to emotional distress as taxable damages. I would advise clients to follow the allocation in the agreement when reporting the income (or not reporting it), and paying taxes. I would tend to err on the side of over- versus under-payment of taxes. g. How will thinss change if and when the CRTRA passes? lflwhen the CRTRA passes, the way you allocate damages in the settlement agreement will change, as will the way the payments are reported and the way the client pays the taxes. If the Act passes as written, cmotional-distress/compensatory damages will not be taxable income. Although you will still allocate a portion o1'the settlement to wage loss and to compensatory damages, you will not allocate any portion of the settlement to punitive damages because those damages remain taxable. That means that you need to pay careful attention to thc language in the settlement agreement dcscribing these damages' Right now, settlement agreements that contain broad language including emotional dislress, pain, suffering, and "all other damages" Plaintiff is seeking, are fine because all of those damages are taxable. Alter the Act passes, that kind of broad, "catch-all" language will not be fine because we should not be lumping punitive damages with compensatory damages. You could even consider expressly excluding punitive damages from this allocation. As forthe wage-related damages, you will still choose between W-2 and 1099/Box 7 for the reporting mechanism, and the client will still pay taxes on this amount in some fashion. But you will not allow the Defendant to report the amount allocated to nontaxable compensatory damages. The settlement agreement should explicitly state that no 1099 will issue as to this payment. If the Defendant reports that amount, it may flag the IRS's attention if your client does not then report it. As for the attorney fee portion, the client will still receive a 1099 for the attorney fee portion, and will follow the procedure outlined above for the "above the line" adjustment. Page8ofl0

10 S<1, for example, you settle your client's gender discrimination case for $100,000 and your attorney fee is $40,000. You allocate $20,000 to back wages and have them reported on W-2. You would then allocate $40,000 expressly to damages for emotional distress, pain and suffering, and humiliation, but excluding punitive damages, and expressly state that this amount will not be reported on Form You have the employer cut three separate checks; two to the client and one to you. Come January, the client will receive a W -2 for the 520,000 in back pay. The client will also receive a 1099 fbr the $40,000 attorney fee. The client should not receive any 1099 relating to the $40,000 payment for the compensatory damages. The client will report the S4b,000 for the attorney fee as income, but will then write in the $40,000 and,,1jdc" on line 36 of her This way, the client is paying taxes only on the $20,000 that was allocated to wage loss. 10. include? indemnifi reement? include or Many employment practitioners will not permit their clients to indemnify a corporation for tax treatment of settlements. Many Defendants will insist that your client indemnify it for taxes, penalties, and interest owed, as well as for professional fees associated with dealing with a tax snafu. My typical practice is to resist indemnification, and compromise with each party u"kno*t.dging that it is responsible for its own tax treatment of the settlcment amounts paid. The fbllowing are examples of language that I have agreed to: t. lan where other side mnilication: The parties understand and agree that they are each responsible for their own respective tax treatment of the payments madc to Client and Client's counsel under this Agreement, with respect to any taxing authority, whether state. local. or federal. Z. More extensive languase. where indemnification became a potential sticking point: Here, the Client agrees to indemnify and hold the employer harmless only where he or she has failed to pay taxes owed. This languagexpressly excepts any failure on the employer's part to pay employment taxes. Except as otherwise provided in this Paragraph, Client agrees to be solely responsible for and legally bound to make payment of the taxes, if any, which are determined to be owed by Client (including penalties and interest related thereto) by any taxing authority on the payments referred to above. Page9ofl0

11 Except as otherwise provided in this Release, client agrees and understands that Employer has not made any representations regarding the tax treatment of the sums paid pursuant to this Release, and Client agrees that she is responsible for determining the tax consequences of such payment and for paying taxes, if any, that may be owed by Client with respect to such payment. In the event a claim for such taxes, and/or penalties and interest, is asserted by any taxing authority as a result of client's failure to pay any taxes Client has been determined to owe, and except as otherwise provided in this Paragraph, Client agrees to, and hereby indemnifies and holds Employer harmless against any and all tax liability, interest, and/or penalties as may be due as a result of Client's failure to pay any taxes Client has been determined to owe as a result of the payments referenced above. Nothing herein shall be construed to render Client responsible for any employment taxes, insurance, or related payments subsequently determined to be the sole responsibility of Employer. IF YOU WANT MORE INFORMATION: The IRS website (www.irs.gov) is actually a very useful placc. You can get.pdf files of all of the IRS fbrms, as well as the instructions for the fbrms. You can also download.pdf files of various IRS publications (such as Publication 525 on taxable income; there is also one specific to back pay), which can be very helpful to explain how things work' If you want to monitor the status of the CR'IRA, a good place to do that is Thomas, on the Library of Congress website. http-://vfww.lq-c.gg-v. Then, click on the link fbr Thomas. You can search by bill number. I have also found useful infbrmation on thesc issues on big firm websites. Bookmark sites for the big labor and employment firms (such as Littler, Mendelson at WI4&lttlgt c*q11), which often post e-newsletters on "cutting edge" topics in employment law. Might as well take advantage of them! O I also have the number of a very good accountant whom I can call and pester with questions, without annoying him too much or having to pay him. He is also someone to whom I refer clients if they don't have their own accountant and want to retain someone to help with these issues. Page l0 of 10

12 26 U.S.C. Q 62(e): this is how the Tax Code defines "unlawful discrimination" (e) Unlawful discrimination defined.--for purposes of subsection (a)(20), the term "unlawful discrimination" means an act that is unlawful under any of the following: (l) Section 302 of the Civil Rights Act of 1991 ( 2 U.S.C. 1202). (2) Section 201, 202, 203, 204, 205, 206, or 207 of the Congressional Accountability Act of 1995 (2 U.S.C. l3l l. I , I 314, 1315, l3l6' or l3l7). (3) The National Labor Relations Act (29 l-j.s.c. l5l et seq.). (4) The Fair Labor Standards Act of l93s (29 U.S.C. 20l, et seq')' (5) Section 4 or l5 of the Age Discrimination in Employment Act of 1967 (29 U.S.C. 623 or 633a). (6) Section 501 or 504 of the Rehabilitation Act of 1973 (29 U.S.C. 791 or 794). (7) Section 510 of the Employee Retirement Income Security Act of 1974 (29 U.S.C. I t40). (8) Title IX of the Education Amendments of 972 (20 U.S.C. l68l et seq.). (9) The Employee Polygraph Protection Act of 1988 (29 U.S.C et seq'). ( l0) The Worker Adjustment and Retraining Notification Act (29 U.S.C. 2 I 02 et seq.). (l I ) Section I 05 of the Family and Medical,eave Act of 1993 (29 U.S.C. 2615). (12) Chapter 43 of title 38, United Statcs Code (rclating to employment and reemployment rights of members of the unifbrmed services). (13) Section 1977, 1979, or 1980 of the Revised Statutes (42 U.S.C. 1981, 1983, or r e85). (t4) Section 703,704, or 717 of the Civil Rights Act of 1964 (42 U.S.C. 2000e-2, , or 2000e- I 6). (15) Section 804, 805, 806, 808, or 818 of the Fair Housing Act(42 U.S.C. 3605' 3605, 3606, 3608, or 3617). (16) Section 102,202,302, or 503 of the Americans with Disabilities Act of 1990 (42 U.S.C. l2l l2, 12132, 12182, or 12203). (17) Any provision o1'federalaw (popularly known as whistleblower protection provisions) prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee fbr asserting rights or taking other actions permitted under Federal law. 1iS; Any provision of Federal, State, or local law, or common law claims permitted under Federal, State, or local law-- (i) providing for the enforcement of civil rights, or (ii) regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law. Copyright Christina M. Royer-2007 Reprinted with Permission

13 This the Form 1099, if you want to see how the IRS designates each box: 3515 COFRECTED PAYER'S W. street address, city, state ZlP code and telephorc no 1 Senis PAYER S f deml numb r " '.' fm RECIPIENT S jdentiri tion numbq.::: '. L '1099-M SC Oat No 14i25J Dopdilmo^l or thc Ttoasury - tnl rnal R vcnue Sftlce Do Not cut or separate Forms on This Page! 2 Royanies C 3 Olher Income ro'm 109$MISC Federal income tax w lhheld R o 5 fishlr bat Proceds 6 ijsdirrl?fc hmhh dre printn$ q Miscellaneous Income Copy A For lnternal Rovenuo Service Center File with Form t096, RECIPIENT'S nam 7 Noilemployee comper$lon 8 Sub3tituto payndrts in hgu ol dividends ot lnlelesl. I.. : ''. For Privacy Aot and Paperwork q q Reduction Act Notice, see the Stre t acldress (rrcludlng apt no ) 9 Payer made dfect $les ol 10 Crop insuran $5,000 of mors 01 oonsuml 2007 General pro{,ucls lo a buyel lnstructions for (recrofit) lor resle ] i $ Forms 1099,. -.i r'-.i:i.i.:i::r'i: i,=11::!! rz ;i. :l:;:ll:::::: lr' r:' City, state, and ZIP code _ ::r: : i:-1..,, r::.:-.::t: _;:! i. 1098,5438, '14 and W-2G. numbd (soe instrucborf) lnd T N not 13 Excess goldon Para Gross Prmceds Pad to paymen(s an anorney ( ls q Strtion 409A defsrals l5b Section 4mA ircone s 18 Stato lax wilhhold ( Y s 17 State/Pay is slato no i8 Slalo i0como Do Not Cut or soparate FOrms on Thls Page

14 Reprinted with Permission of TRIAL(June 2006) Copyright American Association for Justice, formerly Association of Trial Lawyers of America (ATLA) &wwffidffimffi effiffi ffiffiffi#ffideffi ffimffih mw fuffi w The proceeds of your client's settlement for physical injury are frei from income tax, right? I'{ot necessa,rily, if the settlement contain,s a confidentiality prouision. Enter into such settlements carefully and be aware of potential tax consequences. ReNoaI-r O. SoRRnrs eno Nnrr CSoUDHURY lairiti{f attornep have long known that personal injury settlements for physical injuries or sickness can be excluded from the plaintiff's gross income for tax purposes. Butwhat if the settlement contains confidentialityprovisions? Lawyers comrnonly agree to enter into settlcmen t agreements that contain confiden tiality provisions-sometimes being paid a premium for confidentiality. But tlre holding in Am.os a. Contmissioner-a 2003 case that generally has fl own under most practitioners' radarmeans that if you allow your clients to sign setdement agreernents witll confidentiality provisions, you may be unknowingly subjecting them to income tax liability.' Federal income tax rules provide a sweeping definition of taxable gross income: "Except as otherwise provided in this subtitle, gross income means all income fi'om whatever source derit'ed. "' In 1995, the U.S. Supreme Courtstated in Commissioner u. SchLein that any exclusions from gross income must be narrowly construed.u Section 104(a) (2) of the Internal Revenue Code provides one such exclusion for damages received due to personal physical injuries or sickness' It states that gross income does uot include "the amount of any damages (other than punitive damages) received (whether by suit or agleement and wlrether as lump sums or as periodic payments) on account of Personal physical injuries or physical sickness."u Damages received by suit or agreement means "an amount received (otl-rer than workmen's cornpensation) through prosecution of a legai suit or action based upon tort or tort. ffpe rights, or through a settleme ntagreemententered into in lieu of such prosecution."t Wrile it is axiomatic that the exclusion requires a personal injury or physical sickness, "not all recoveries growiug out of an action based on a Personal pirysical injury are excludable under section 104(a) (2)."u And a claimant who seeks to exclude settlement proceeds from his or her gross income car-ries the burden of proving the IRS wrong in its assessment that the income exchrded is actually taxable as gross income.t Many reported cases address whether the $104(a) (2) exclusion applies to different claims, causes of action, and injuries.o To determine whether your client's damages are excludable, you need to r"rnderstand the potential tax consequellces of confidentiality provisions in a settlement agr-eement. Arnos u. Corxtrttissioner On January 15, 1997, Eugene Amos was operating a handheld televisior-r camera during a basketball game between the Minnesota Timberwoives and the Chicago Bulls. Duringplay, Bullsforward Dennis Rodman j umped for a ball over the end line, Ianding in a goup of photograpilers and twisting his ankle. As he renrrned to tb.e court, Rodrnan kicked Amos in the groin. An arnbulance took Amos to the l-rospital with nonspecfic complaints of pain in the groin, neck, and back. s6 lrnlet June zoog

15 Shortly al'ter the incident, Rodman must meelbefore a recovery can be excluded claim withorrt having to expend addi- under $ i 04(a) (2): First, the taxtional defense costs" aud Amos settled A-rrros's personal injury clarm for $200,000. Notsurprisingly, payer must demonstrate that the underlying cause of action giving rise to testing thatrodman paid the entire set- I testimonyfrom Arnos's attorney at- it contained confi dentiaiily provisions. \44ren Alros filed his tax rerurn for thatyear, he excluded from his gross ir-rcome the $200,000 l-re received from Rodman as personal injury damages. The IRS invesriplated and concluded drat, exceptfora minimal amounl ($l ), Arnos was not entitled to exclude the settlement proceeds because the payment was made almost exclusively for the confidentialiry provisions, not for personal injuries. Amos appealed to the U.S. Tax Court. After a detailed discussion of both the settlement agreement's confidentiality provisions and the facts of the case, the the recovery is "based upon tortor tortq.pe rigi-rts"; and second, the taxpayer mlrst show that tire damages were received "orr account of perso[al injuries or sickness."rr The Tax Court therr noted that when darnages are received under a confidential settlement agreement such as theamos-rodman agreement, the following factors should be con- from tlerrrent amolrnt to Amos on account of his physical injuries I Amos's medica.i history, rvhich showed drat he had potenria-l claims against Rodrnan for possible physical injuries resulting from dre incident." The court held *rat, althougl'r Rodman's domillant reason for paying the settlement amolrnt was to compensate Amos for his claimed physical injuries, Tax Court concluded that $80,000 of tlie $200,000 was attributable to the prouing th,e IRS l.wong in its a,ssessment that th,e confidentiality provisions and was taxable underamos's gross income.n The Amos court quoted at length from t-he conhdential settlenrent aqreementand release: sidere d in deterrnining whether they are excludable: he paid part of it for odrer reasons. The settlement agreement expressly [P]art of tlre consideration for this agree I the nature and character of the provided that Rodman would pay a ment and release includes an agreement dtat claim that was settled and its facnral basis (this does notinclude an inquiryinto Amos's promise not to defame hirn, portion of the proceeds in return for Rodmm andamosshall notatanytime frout the date of this agreement md release Forward the claim's validity, which is irrelevant) disclose existing terms of the settlement dispmge or defame each other.... agreement, publicize facts relat- t any express languagc in dre settlement agreement stating what amount ed to tl-re incident, or assist in any crim- [T]he terms of t.his agreement and release shall foreverbe kept confidential and not released to any news media pemonnel the defendant paid to settle the plaintiff's pclsorral ir!rrry clairn court determined that these provisions inal prosecution agains t Rodman. The or rcpresentatives Lhereof or to any olher person...! tl-re defendant's dominantintentin were evidence enough that part of the Amos agrees not to make any further malcing the palrner-rt (a critical factor) settlemellt pa)4nentwas not related to publicstatementrelating to Rodman or the incident or to grant any interviervs relatirtg! the plaintiff's belief in the reason physical injuries. to Rodman or thc incidenl.-... for-receiving dre pa)tnent (althor,rgh this The court reviewed the entire record and noted that Amos had the To discourage:rnybreach o[ tire terms oi is of ancillary importance to the defendant's inte ntin making the payment).r'z burden of proving that the whole set- this agreement and relea-se, arrd to compensate Rodman should any such breach To meet his burden of Proof, Amos tlement amolrnt was intended to compensate hirn for physical injuries. Be- occtrr, it is r-rnderstood and agreed tliat Amos shall bc liable for liqlridate damages introduced the following evidence to in the amount of t$200,0001 in the event connect his proceeds from the confidential settlement agreement with his specific amounts of the $200,000 to calrse the agreement did not allocate sr:ch a rnaterial breach occurs.... Amos Rlrdrer represents, promises, and potential claims for physical injr-rry: physical inj uries and other faclors, the agrees tlrat, x a part of tlte considcradon E a provision from the agreement itself, which expressiy provided that ltod- $i80,000 for the confideutialiry provi- court determined that Rodman paid for tjris agrecmentmd release, he has communicated to the MinneapoLis Police Departnent thal he does notrvish to purslte a marl's payrnenl to A.mos released Rociman "from anyand allclaims andcauses that did not pertain to pl-rysical insions in the settlement agreenent criminal charge against Rodman, ancl drat he has communicated that lre will not cooperirte of acliou of any type" thatamos l-reld in iuries, so this amount lvas taxable as in a:ry crinrinal irtvestigation con- connectiorl with tl-re incident ceming the incidetrt.ro I a declaration dratrodman signed, RaNlelrO. SonRnr-s is a parttter itt In its iegal analysis, the Atnos court cited the Supreme Court's decision in stating that he entered into the settlement agl-eelxe nt "to resolve any potential Abrahant, Wathins, Nicltols, Sorrels, NIattlrcws U Ftietzd in, Hottstotz.Nr.rr' claims and that the settlement agree- Cnounuuny is a recent graduate of Selr.leia", whicl-r summarized the tvvo independent requirements the taxpayer ment was intended to resolve Amos's the Uniua'sit1t of Houstott Law Cen.ter. A claimant who seeks to exciude settlement proceeds his or her gross income carries tlrc burden of itzcome excluded is achtally taxable as g'ross income. TRIAL Jlltxe 2oo 6 sz

16 gross income. The court's allocation of $80,000 apparently was arbitrary. After Antos, plaintiff iawyers who do not address these issues maybe improperly advlsing their clients on the net recovery they will receive after taxes and other considerations. Tax tips Rather than face unwelcome tax consequences-or an unwelcome legal malpractice lawsuit-consider these op tions and, if necessary, discuss them with your client. before you complete tion between the physical injury and the settlement. Wrether the settiement payment is exclrrdable from gross income depends on the nature and character of the claim asserted. To ensure that proceeds will be excluded, they should be traceable to tl-re physical injury claim. The release should descdbe the injuries the plaintiff suffered and how they are connected to the settlement. Use clear, unambiguous ianguage to avoid any misinterpretation. For example: "The plaintiff's injuries include brain damage and spinal in- The pl,aintiff could cor*ider obtair;xng a priuate ie^s nrling based on his or her specific fanual situation in the proposed settlem.erxt agreement ta daennirw whether the IRS will require the plaintiff to allocate some or all of the ptoceeds to gross 'income. your next settlement. Do not enter into a confidentiality agreernent- Far too often, confidentialicy provisions are part of the standard florms defense lawyers use when preparing a release and settlement agreement. But confi dcn tialiry often is unnecessary. Expressly disclaim any consideration for confidentiality. If none of the sett-lement is being paid for confidentiality, the agreementshould expressly state that. Both the expres slatement that no rrioney is being paid for a confidentia-lity provisior-r and another that all consideration is being paid to the plaintiff for physical injuries and sickness will help defeatany claim by tl're IRS that the money was received for the confidentiality provisior-r. Get an express statement from the defendant that payrnent is not for confidentiality. Although the release /settlement agr:eement could include this language, a separate statement or affidavit from the payer setting forth his or her dominant purpose and intent for the payrnennvouid be better. Create a causal connection betrveen injuryand setfl ement. Expressly se t out the ciaims that create a causal conllecsa ITRIAL Jzr,tze zoo6 juries, and settlement is for those injuries and loss of earning capacity." Segregate the amountpaid for confidentiality. If the defendant is papng some consideration for the confidentiality provision, the release should expressly state what amount of the procccds is allocatcd for the plaintiff's physical injuries and whatamountis for confidentiality. Of course, you should advise the clicnt of the related tax consequences and direct him or her to consuit with a tax adviser (as is probably a good practice in all cases). Demand extra money for including a confidentiality provision. The confi dentiality provision often does not come Llp until the plaintiff attorney receives the release and settlement papers. If tiris occurs and the defendant demands confidentialiry, it is not unreasonable [o requesl that addirional consideration be paid to include the confidentialify provisions. Make a clai'n for physical injuy ear. ly in the settlement process. Many claims allow recovery for both taxable and nontaxable damages. The settlementproceeds are more likely to be excludedunder$i0a(a) (2) if the plaintiff asserts his or her physical injury claims before the se ttlement process be ginswhich is ideal-or as early in the settlement process as possible. If the plaintiff asserts a claim late in the process, he or she faces th.e chance that a court will strike down the exclusion and allocate all the proceeds to gross income." Include an indemnification provision. Plaintiffs routinely indemnify defendants for later ciaims. But if the defendant insists on a confidentiality provision andrefirses to provide some of the addirional safeguards noted above, it is not unreasonable to ask the defendant to indemnify the plaintiff for the unforeseen tax consequences he or she mayface later. Obtain a private fp$ lrrling. AIthough it typically is not practical, the plaintiff could consider obtaining a private IRS ruling based on his or her specific facrual situation in the proposed settlement agreement to determine whether the IRS will require the plaintiff to allocate some or all of the proceeds to gross income. Amos a. Com,missionn spotlighted a previously unaddressed tax liability issue in settlements-and highlighted the dangers of entering into settlement agreements with confi dentiality provisions. If your client's settlement agreement requires a confidentiality provision, consider your- options carefully. Ignoring potential tax liability may leave your clientwith less than he or shc anticipated-and may leave you exposed to an unnecessarv malpractice claim. I Notes 1. 86T.C.M. (CCH) 663 (2003) u.s.c. 501 (a)(2001) U.S. 323, 328 (ie95) u.s.c. SIOa(a) (2)(2001) C.nR. 51,1041(c) (2006). 6. Institutc on Fedcral Taxation, USC Larv School, Il'Iajor Tax Plannhry for G13, ar r308.1 (2004). 7. Sce U.S.TaxCt. R. 142(a) (200-65). 8. See Institute on Federal Taxation, supra note Atnoq86'l.0M. (CCH) Id. at U.S.323, ,4rnos, 86 T.C.M. (CCH) 663, Id. 14. See, e.g, King-Knoll v. Comm'r, 86 T.C.M. (ccrj) 3e6 (2003).

17 T. C. Memo UNITED STATES TAX COURT trugeneamos, JR., COMMI SS IONER OF INTERNAL Petitioner v. REVENUE, ResPondent Docket No Iiiled December I, 2003 Terrance A. Costello, for petitioner BLaine C. HolidaY, for respondent MEMORANDUM F]NDINGS Otr tract AND OPINION CHIECHI,Judge:Respondentdeterminedadeficiencyof $61, 668 in petitioner's Federal income tax (tax) for 1991 ' The only issue remaining for decisionl is whether the lpetitioner concedes the deficiency (notice) issued to disalf ow $6,'755 of deductions determinations in the notice of petitioner with respect to 1991 to claimed by PeLitioner in Schedule (continued... )

18 - 2 $200,000 Settfement amount (settlement amount at issue) that petr-troner received in I9g1 in settlement of a claim is excl-udable under section 104(a) (2)' from petitioner's gross incomefort-hatyear.weholdthat$l20,o0oisexcludableand that- $80,000 is not. FINDINGS OF FACT Most of the facts have been stipulated and are so found' AtLhetlmepetitionerfiledthepetit-ioninthisCaSe'he res ided in MinneapoJ-is, Minnesota ' During:_gg"T,petitionerwasemployedasatelevisioncameraman. In that capacity, on January 15, 1-991' petitioner was operalingahandheldcameraduringabasketballgamebetweenthe Minnesota Timberwolves and the chicago Bulls. At some point during that game, Dennis Keith Rodman (Mr' Rodman)' who was playing for the Chicago Bulls, tanded on a group of photoqraphers, includrng pet.itioner, and t-wisted his ankle' Mr' Rodman then kicked petitioner. (we shall refer t-o the foreqoinq incident involvrng Mr. Rodman and petitioner as the incident ' ) t(...continued) A, Itemized Deductions, and $1,L18 of deductions claimed by petitioner rn Schedule Ct Profit or Loss From Business' There are other determinations in the notice that are computational in that resolution of the issues re1a1-ing to such determinat-ions flows automatrcally from our resolution of the issue addressed herern.,.al]-sectionreferencesaretothelnternalrevenuecodein eff.ect for the year at ]ssue. AII RuIe references are to the Tax Court Rules of Practice and Procedure '

19 - 3 onjanuaryl5,iggl,shortlyaftertheincident,pet-itioner WaStakenbyambu}ancefortreatmentatHennepinCountyMedicaf center. Petrtioner informed the medical personnel at that medrcal- center (Hennepin county medical personnel) that he had experienced shooting pain to his neck immediately after havrng beenkickedrnthegroin,butthatsuchpainwassubsiding'the HennepinCountymedicalperSonnelobservedthatpetitionerwaS abletowalk,butthathewaslimpingandcomplainedofexperrencing pain. The Hennepin County medical personnel did not observeanyotherobvioussignsoflrauma.petitionerinformed the Henneprn county medical personnel that he was currently Laktng parn medication for a preexisting back condition' The Henneprn county medicaf personnel offered additional pain medj'cations to petitioner, but he refused those medications ' After a dispute wlth the Ilennepin county medical personnel concerning an unrelated medrcal issue, petitioner left Hennepin Count.y Medical Center without having been discharged by them' While petrtroner was seeking treatment at Hennepin County Pearson (Ms. Pearson) about Medicaf Center, he conlacted Gale the incident. Ms. Pearson was representing him with respect to representing Plaintiffs rn an atlorney who had experience in subsequent conversations and a personal injury lawsuits. After meeting with Petitioner, Ms. Pearson agreed t-o represent him with respect to the incident.

20 visj.t report On JanuarY 15, 1ggl, after the incident and petitioner's to the HennePrn (police report In t-he Po-L Lce repor L ' - 4 County Medical Center, petitioner filed a ) with the Minneapolis PoIrce Department ' petitioner claimed that Mr ' Rodman had ass.lult-ed him. OnJanuaryl_6,19g'l,petitionersoughtmedicaltreatmentat the Veterans Affairs (va) Medical center. The medical personnel atthatmedrcalcenter(vamedicalpersonne])tookx_raysof petitioner's back. Pet'itioner complained t'o the VA medicaf personnelabouthrsgroinarearbuthedidnotadvisethemthalhe was experrenclng any symptoms related to that complaint ' The VA medical personnel determined that there was no swelling of, but they were unable to ascertain whether there was bruising around, pel,itroner's groin area' The VA medical personnel gave petitionersomepainmedicationandtoldhimtocontinuet-aking his other prescribed medications ' The VA medical personnel preparedareportregardingpetitioner,sjanuaryt6,i99lvisitto the VA Medrcal center. That report indicated that, except for certain disk problems t.hat. petit-ioner had since at least as early asfebruary14,igg5,..thevertebraeareintactandtheremaining disk spaces are normal. " Veryshort-lyaftertheincidentonadatenotdisclosedby the record, Andrew Luger (Mr. Luqer), an attorney representing Mr.RodmanwithrespectLotheincident'ContactedMs.Pearson.

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