Uncle Sam and Settlement Proceeds: Is the Settlement Taxable?

In negotiating the settlement of an employment law case, will the settlement proceeds be taxable, reportable or subject to withholding and payroll taxes? Over the last few years, amendments to the tax code and U.S. Supreme Court decisions have significantly limited the types of claims that are excluded from taxable income.

The Internal Revenue Code, ("Code") 26 U.S.C. §61, provides that all income received is taxable, unless specifically excluded from gross income. Section 104 of the Code provides for a number of types of income that are excluded from gross income, and therefore not taxed. The exclusions are construed narrowly.

Effective August 20, 1996, Congress amended the portion of Section 104 under which employment discrimination claims had been excluded from income. Under revised Section 104(a)(2), only damages received "on account of personal physical injuries or physical sickness" are excluded from gross income (emphasis added). The statute further provides that emotional distress damages are not to be treated as physical injury or physical sickness and are only excluded to the extent they cover medical expenses due to the emotional distress not previously deducted. Amounts received for emotional distress exceeding actual medical costs are included in gross income. The statute further provides that all punitive damages are taxable regardless of the origin of the claim.

The 1996 Amendments resolved some of the confusion resulting from the U.S. Supreme Court decision in Commissioner v. Schleier, 515 U.S. 323 (1995), holding that all damages awarded under the Age Discrimination in Employment Act (ADEA), 29 U.S.C. §§ 621 - 634, were taxable. In Schleier, the Court reasoned that awards under the ADEA did not fall within Section 104(a)(2) as defined at that time because they were not "on account of personal injury or sickness" even if they could be characterized as damages "based upon tort or tort-type rights" under the regulations interpreting the exclusion. See 26 C.F.R. 1.104-1(c).

The decision in Schleier began a shift away from excluding employment discrimination claims from taxable income. Previously taking guidance from the regulations, the Court held in United States v. Burke, 504 U.S. 229 (1992), that damages recovered under pre-Civil Rights Act of 1991 Title VII claims did not fall within the exclusion of Section 104(a)(2) because the statute did not provide for tort remedies such as compensatory and punitive damages. In light of Burke, the Internal Revenue Service (IRS) issued Revenue Ruling 93-88, providing that damages (back pay and compensatory) received for disparate treatment discrimination under Title VII, (post Civil Rights Act of 1991), 42 U.S.C. §§ 2000e - 2000e-17, 42 U.S.C. §1981 and the Americans With Disabilities Act (ADA), 42 U.S.C. §§12101-12213, were excluded from gross income under Section 104(a)(2) as damages for personal injury. After Schleier, the IRS suspended Revenue Ruling 93-88.

The 1996 Amendment further limits those claims that may give rise to tax-free damages by requiring that the claim arise out of physical injury or physical sickness. For example, non-physical personal injuries, such as defamation would now result in taxable damages unless actual physical injury resulted, where previously they were routinely excluded from gross income. Further, emotional distress damages only will be tax-free to the extent they cover actual medical costs resulting from the emotional distress.

Thus, for settlements (or awards) paid after August 20, 1996, only those payments attributable to a physical injury or sickness are tax free. Lost wages, compensatory and punitive damages arising from claims of employment discrimination are taxable, except for actual medical costs due to emotional distress. Because the payments are taxable to the plaintiff, the employer must report the payment, either on Form 1099 or W-2. Where the damages reflect lost wages, the employer must withhold taxes under Form W-2 and must pay payroll taxes on the amount. Only those damages arising from physical injury, such as assault, battery or sexual harassment involving physical touching will be excluded from gross income and not reportable.

Allocation Tips

In reviewing the parties' allocation of settlement proceeds as taxable or excluded, the IRS looks to the origin of the claims being settled, regardless what tax treatment the parties agreed upon. Under some circumstances, the allocation of the entire proceeds as excluded may be appropriate, e.g., a claim of sexual harassment involving physical contact where no adverse employment action was taken.

Where the parties allocate some proceeds as excluded, it is important that the settlement agreement explicitly state that the funds are being paid to settle claims of "personal physical injury or physical illness." Where no funds are being allocated to settle a claim that would otherwise give rise to taxable damages, the agreement should stipulate what consideration is supporting the release of that claim, i.e., "in exchange for the release of the claim of lost wages, the employer is willing to enter into this Settlement Agreement to settle the employee's other claims."

Where the basis for an allocation of damages as excluded is questionable, the IRS will likely resolve that question against the taxpayer. The potential liability to the employer in the event that payments are reallocated as taxable wages include the federal and state income taxes to be withheld, FICA, FUTA, state unemployment taxes and other taxes that should have been withheld, such as local taxes or state disability insurance program taxes. Further, the employer may incur penalties and interest for failing to withhold taxes, failing to file a Form W-2 and failing to pay employment taxes on time. Where payments are reallocated as taxable, but not wage income, the employer may be liable for penalties and interest for failing to report the income. Whether payments will be characterized as wages remains an open question as to some types of damages, but certainly back pay and front pay would qualify. Employers may want to negotiate a provision requiring the plaintiff to indemnify the company in the event of an adverse tax decision on payments allocated as excluded from income, but such provisions may prove difficult to enforce. We recommend clients seek advice of counsel where they have questions as to the taxability of settlement payments to minimize the risks of reallocation.