United States: Tax Issues in Employment Settlements

Last Updated: June 18 2004
Article by Patrick Derdenger and Randal T. Evans

Originally published in 2001

I. INTRODUCTION

Employment-related disputes are usually resolved in one of two ways. Either the case proceeds to judgment, or the parties negotiate a settlement before a j udgment is rendered. The parties also may negotiate a settlement after a judgment is rendered in order to avoid the appeals process. This outline focuses primarily on the tax issues of employment-related settlements. Nevertheless, the manner in which an employmentrelated dispute is settled has little, if any, significance for federal tax purposes. See Longino Est. v. Comm'r, 32 T.C. 904 (1959) (settlement); Levens v. Comm'r, 10 T.C.M. 1083 (1951) (arbitration award). Thus, the tax rules relating to settlement payments remain the same if the dispute proceeds to judgment.

In negotiating a settlement, the parties must address a number of tax-related issues (the same issues may arise after a judgment has been rendered). Although the tax issues are usually not the most important issues in negotiating a settlement, they should not be left to the last minute or, worse yet, ignored completely. If the parties have not settled the tax issues in advance (and sometimes even if they have), they may find themselves entangled in a secondary dispute over the tax consequences of the settlement payments.

The following are some of the most frequently encountered questions that arise in connection with the settlement of employment-related claims:

  • Are the payments excludible from income for federal income tax purposes? If not, is the recovery amount ordinary income, capital gain, or return of capital? (see Sections III and IV, below).
  • When a single action involves multiple claims, each having different tax consequences, how should the settlement payment be allocated among the various claims? (see Section V, below).
  • What are the payor's withholding and reporting obligations (e.g., is the payor obligated to withhold taxes and send a Form W-2 to the payee and the IRS or issue a Form 1099 for the amount of the payment, or neither)? (see Section VI, below).
  • Can the payor take a deduction for the settlement payment? If yes, is the payment deductible currently or must it be capitalized? (see Section VII, below).
  • Under a structured settlement (when the recovery amount is spread out over a number of years), when does the payee recognize gain? When does the payor take a deduction? What types of liabilities under a structured settlement may be assigned to a third-party and what are the tax consequences of assigning a settlement-related liability? (see Section VIII, below).

Each of these questions is addressed below. In examining these questions, it will be helpful to first look at the general tax principles that apply.

II. GENERAL FEDERAL INCOME TAX PRINCIPLES

A. Federal Law Governs

While the interests and rights of the parties to an employment-related dispute are most often determined by state law, the tax consequences of any recovery are, for the most part, determined by federal law. Brabson v. United States, 73 F.3d 1040 (10th Cir. 1996) (noting that "state law determines the nature of the legal interests and rights created by state law, but ... the federal tax consequences pertaining to such interests and rights are solely a matter of federal law"); see also Helvering v. Stuart, 317 U.S. 154, 162, (1942); Imel v. United States, 523 F.2d 853, 855 (10th Cir. 1975).

Because the tax consequences of settlements are primarily determined by federal law, this outline focuses on federal tax law as established and interpreted by the following sources:

  • The Internal Revenue Code of 1986, as amended (26 U.S.C.) (the "Code");
  • IRS Regulations (26 C.F.R.) (the "Regulations" or "Regs.");
  • Federal case law;
  • Official IRS documents, including Revenue Rulings ("Rev. Rul.") and Revenue Procedures ("Rev. Proc."); and
  • Internal IRS Documents, including Private Letter Rulings ("PLR") and Technical Advice Memorandum ("TAM") (internal documents do not have the force of precedence, but do provide guidance on the IRS's position on a particular issue).

B. General Concept of Gross Income and Exclusions

1. Gross Income Includes All "Accessions to Wealth"

For federal tax purposes, gross income includes "all income from whatever source derived." Code § 61(a). In the landmark case, Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955), the Supreme Court established that the "sweeping scope" of § 61 applied to any "accession to wealth," and not just payments for compensation:

Here we have instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete [control]. The mere fact that the payments were extracted from the wrongdoers as punishment for unlawful conduct cannot detract from their character as taxable income to the recipients. Respondents concede, as they must, that the recoveries are taxable to the extent that they compensate for damages actually incurred. It would be an anomaly that could not be justified in the absence of clear congressional intent to say that a recovery for actual damages is taxable but not the additional amount extracted as punishment for the same conduct which caused the injury.

Id. at 431.

The "sweeping scope" of § 61 has been repeatedly emphasized by the Supreme Court. See, e.g., Schleier v. Comm'r , 515 U.S. 323, 327-28 (1995). Thus, any gain constitutes gross income unless it can be demonstrated that it falls within a specific exemption under the Code. Schleier, 515 U.S. at 328.

2. Settlement Payments Are Income Unless Specifically Exempted

Since money or property received pursuant to a judgment or settlement is an accession to wealth, clearly realized, and over which the recipient has complete control, it is includible in the recipient's gross income under § 61 and the Glenshaw Glass rationale, unless specifically excluded under the Code.

The only exclusion in the Code relating to employment settlements is § 104, which provides a limited exclusion for amounts received pursuant to the resolution of certain personal injury claims. For payments that do not qualify for the § 104 exclusion (e.g., non-personal injury claims), the issue generally is not whether the settlement amount is excludible from gross income, but whether the payments are ordinary income, capital gain, or return of capital.

C. Origin and Nature of the Claim and Allocation of the Damages Awarded

As noted above (Section II.A), the federal tax consequences of settlements are solely a matter of federal law. Nevertheless, state law may play an important role in determining the "origin and nature of the claim," which has a significant effect on the tax consequences of the settlement payment.

In the context of employment settlement payments, the origin and nature of the claim determines (i) whether the payment is excludible from gross income; (ii) if the payment is not excludible, whether it is ordinary income or capital gain; (iii) whether the payment is deductible as a trade or business expense or a production of income expense; and (iv) whether the payment may be deducted currently or capitalized. The origin and nature of the claim also has a significant impact on the payor's withholding and reporting requirements.

Under the origin and nature of the claim doctrine, the taxpayer should be restored to the same position with respect to tax liabilities that the taxpayer would have been in had the injury not occurred. This is accomplished by treating the settlement amount (or judgment award) as a substitute for the item of loss or economic detriment that is alleged in the plaintiff's claim and then assigning the settlement amount the same tax treatment that the lost item would have received if the loss not occurred in the first place. Thus, for example, where an employee settles a suit against a former employer for breach of contract and age discrimination, the nature of the settlement payment is essentially a substitute for salary and will be taxable as ordinary income. See Alexander v. IRS, 72 F.3d 938 (1st Cir. 1995).

The origin and nature of a claim may be determine d by looking to the complaint, the history of the negotiations or settlement discussions, the settlement agreement, and state law. See, e.g., Rev. Rul. 85-98, 1985-2 C.B. 51 (IRS noted that the best evidence available to determine how payments received pursuant to a judgment or settlement should be characterized is the taxpayer's complaint); Brabson v. United States, 73 F.3d 1040, 1044 (10th Cir. 1996) (looking to state law to determine the nature of prejudgment interest).

III. AMOUNTS RECEIVED ON ACCOUNT OF PERSONAL INJURIES OR SICKNESS

Code § 104 provides that certain payments relating to a claim for personal injury or sickness are excludible from gross income. In addition to other exclusions not applicable here, § 104 provides an exclusion from gross income for the following categories:

  • amounts received under workmen's compensation acts as compensation for personal injuries and sickness, § 104(a)(1);
  • damages (other than punitive damages) received for physical personal injuries or physical sickness. § 104(a)(2);
  • certain amounts received through accident or health insurance for personal injuries or sickness, § 104(a)(3);

The exclusion under § 104 is not available for payments attributable to medical expenses for which a deduction was claimed in a prior year. § 104(a). This rule prevents taxpayers from claiming a double tax benefit; that is, taking an exclusion and a deduction with respect to the same amount.

A. Workmen’s Compensation Claims – § 104(a)(1)

Section 104(a)(1) excludes from gross income amounts received by employees (or their survivors) under a workmen's compensation act (e.g., Longshoremen's and Harbor Workers' Compensation Act, 33 U.S.C. § 18) or a statute in the nature of a workmen's compensation act on account of personal injuries or sickness incurred in the course of employment (i.e., occupational injuries).

This exclusion does not apply to amounts received from a retirement pension or annuity, even if the employee's retirement is caused by an occupational injury, if the amount is determined by reference to the employee's age or length of service. Regs. § 1.104-1(b). Also, the exclusion under § 104(a)(1) is limited to the amount provided in the applicable workmen's compensation statute. Id. See also PLR (IRS Private Letter Ruling) 200013005.

The exclusion for workmen's compensation payments is available only if the following three requirements are satisfied:

  • The amount must be received under a law that qualifies as a workmen's compensation act or as a statute in the nature of a workmen's compensation act;
  • The amount is received on account of personal injuries or sickness incurred in the course of employment (i.e., occupational injuries or sickness); and
  • The amount is not a retirement pension or annuity measured by the employee's age, length of service, or prior contributions.

Each of these requirements is discussed in more detail below.

1. Qualified Law Requirement

With respect to the first requirement, the term "statute" has been construed liberally to include regulations issued under statutory authority. In Dyer v. Comm'r, 71 T.C. 560 (1979), for example, the Tax Court held that, under the statutory law of New York State, the New York City Board of Education had the authority and duty to provide workmen's compensation for its employees who were injured in the line of duty, that the Board's regulations had the force and effect of law and constituted "a statute in the nature of a workmen's compensation act," and that, as a result, amounts received by a New York City school teach were excludable from gross income under § 104(a)(1).

On the other hand, private contractual arrangements providing for disability benefits generally do not satisfy the qualified law requirement. See, e.g., Wallace v. U.S., 97-1 USTC (CCH) ¶ 50,476 (S.D. Ind. 1997), aff'd 139 F.3d 1165 (7th Cir. 1998).

2. Occupational Injuries Requirement

In addition to the qualified law requirement, to qualify for the § 104(a)(1) deduction, the payment must be compensation for injuries or illness suffered in the course of employment. Regs. § 1.104-1(b). If a statute provides for compensation to employees on account of injuries or illness irrespective of whether the injury or illness is workrelated, the statute will not qualify as a workmen's compensation act or a statute in the nature of a workmen's compensation act. For example, in Rev. Rul. 83-77, 1983-1 C.B. 37, the IRS ruled that payments under a police union contract did not qualify for the § 104(a)(1) deduction because (in addition to not being a statute), the contract provided for payments on account of injuries or illness other than those suffered in the course of employment. See also Kane v. U.S., 43 F.3d 1446 (Fed. Cir. 1994), aff'g 93-1 USTC (CCH) ¶ 50,168 (Fed. Cl. 1993) (federal judicial disability statute not in the nature of a workers' compensation act because it did not distinguish between work-related disability and non-work-related disability).

3. Payments Must Not Be Based on Age, Length of Service or Prior Contributions

A statute that provides for payments for retirement pension or annuity benefits determined by reference to the employee's age, length of service, or prior contributions will not qualify as a workmen's compensation act or a statute in the nature of workmen's compensation act under § 104(a)(1). Regs. § 1.104-1(b). The §104(a)(1) exclusion will not apply to such payments even if an employee is forced to retire due to an injury or illness incurred in the course of employment. See, e.g., Mabry v. Comm'r, T.C. Memo 1985-328 (when taxpayer turned age 55 his disability retirement benefits were recomputed as if he had taken service retirement on that date and were therefore no excludible); Wiedmaier v. Comm'r, T.C. Memo 1984-540, aff'd, 774 F.2d 109 (6th Cir. 1985) (reduction in benefits after 25 years of "creditable service" did not constitute a continuation of former disability retirement benefits, but instead represented regular retirement benefits based on length of service); Rev. Rul. 80-84, 1980-1 C.B. 35; Rev. Rul. 80-14, 1980-1 C.B. 33.

B. Damages Received for Personal Injuries or Sickness – § 104(a)(2)

Code § 104(a)(2) exempts from taxable income all damages (other than punitive damages) received pursuant to a judgment or settlement of a claim for personal injury or sickness, but only if such injury or sickness is physical. The current language of § 104(a)(2) was adopted pursuant to an amendment by The Small Business Job Protection Act of 1996, P.L. 104-188 (the "SBJPA"). The revised provision is effective for damages received after August 20, 1996, in taxable years ending after such date.

Prior to 1996, § 104(a)(2) provided an exclusion for damages received on account of both physical and non-physical personal injuries or sickness. Following the 1996 SBJPA amendment, § 104(a)(2) limits the exclusion to damages received on account of a physical personal injury or sickness. A brief overview of the law before the SBJPA is necessary to provide context for the current rules relating to damages for physical injuries or sickness.

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