According to the Internal Revenue Code, non-punitive damages received as compensation for physical injuries or sicknesses are not included in gross income. IRC §104(a)(2). Payments for non-physical injury are also excluded from gross income for tax purposes as long as the origin of the claim is from a physical injury. Id. Damages due to wrongful death, pain and suffering from a physical injury, or lost wages from a car wreck would all be excluded from gross income under section 104(a)(2).
The IRS has developed audit guidelines to determine whether settlement proceeds fall under gross income. These guidelines are entitled "Lawsuit Awards and Settlements" and fall under the IRS Market Segment and Specialization Program. The purpose of the program is to target damages that "otherwise fall through the gap of unreported income." “Lawsuit Awards and Settlements,” Market Segment and Specialization Program http://www.irs.gov/pub/irs-mssp/a9lawsut.pdf. The document instructs auditors to look for unreported punitive damages, confidentiality clauses, or anything that may have gone unnoticed. Traditionally, the IRS has given more weight to the statements made by the plaintiff in the original complaint to determine whether settlement moneys are from a punitive or otherwise taxable claim.
Another necessary consideration is that post-judgment interest is taxable. This can be very significant. If a verdict is compromised, the attorney should negotiate away the interest first.
When settlement proceeds consist of taxable and non-taxable damages, proper allocation is critical. While the general rule is to follow the old adage of substance over form, ensuring that the settlement takes the proper form is still an essential part of the settlement planning process. Settlement documents should clearly outline the basis for and amounts of the various damages paid in the settlement.
It is also important to know when to employ the use of a Qualified Settlement Fund (QSF). These funds sometimes affectionately called 468B Funds after the section of the IRS code that governs them are essentially a judicial allocation by a court. QSFs were developed to ease the distribution of settlement proceeds in large class-action settlements like Exxon Valdez. Today these tools can be an appropriate action for single claimant cases as well. A good settlement planner will know when the use of a QSF is appropriate.
This decision had several important impacts. Most plaintiffs receiving taxable damage settlements must include the gross amount of the settlement as income, and then deduct the attorney's fee "below the line." This would subject the client to phase-outs and exemptions limits and may create an alternative minimum tax (AMT) problem where the client's income is substantially higher. The solution is to structure both the plaintiff's recovery and the attorney's fee. This will defer taxes over a period of years and negate the AMT issue entirely. Commissioner of Internal Revenue v. Banks & Banaitis, 543 U.S. 426, 430 (2005).