WIN IN COURT WITHOUT LOSING TO IRS

Of course the tax man wants a cut whenever you make a buck — even if you win it in court. But not all legal proceeds are taxable, so how you structure a settlement can save both sides a lot of money.

We all know we’re supposed to pay taxes on our income. But what exactly IS income?

The answer is more complicated than you might think, and, if you’re not careful, you might have to pay taxes on something you never expected.

The courts have defined “income” to include all accession to wealth, clearly realized, over which you have dominion. Essentially, that means income is anything of value that you receive to do with as you please, for which you do work or because it is obligated by contract. And, unless it’s excluded as income by the Constitution or by statute (like municipal bond interest), it’s taxable!

However, one of the most basic tenets of tax practice is that if money received merely returns you to your original starting point, if it just makes you “whole” again, it’s not “accession to wealth” and thus isn’t income.

Taxed on the Gains

When you sell stock, only the gain, the excess of what’s received over your cost basis — normally, what you paid to buy the stock — is taxed as income. Likewise, if you lose an arm and receive an insurance settlement for that loss, the settlement isn’t taxed because it only makes you “whole” again. (At least, in a financial sense.)

For years, that seemed reasonable — if anything in our Tax Code can be considered “reasonable” — until the Small Business Job Protection Act of 1996 changed all the rules.

The big rule change on personal injuries is this: Unless the injury is physical, any settlement or award is taxable. That makes awards for discrimination, emotional distress and/or injury fully taxable — even though these awards are intended only to make you whole again!

For a verdict or settlement to be tax-free, it must be structured to meet two new code requirements:

What appears simple and straightforward — as Cole Porter famously claims in his opera, Porgy ’n’ Bess — “it ain't necessarily so!” Here’s where creative planning and litigation can save substantial dollars.

Planning the Settlement

Let’s look at emotional distress. Emotional distress can produce physical symptoms — headaches, stomach pains, insomnia and the like. As a result, you may believe that any award or settlement for emotional distress might not be taxable. Wrong! Emotional suffering, no matter how bad the headaches, doesn’t come free of a tax bill. Remarkably, the headaches do! Physical injury, see?

But let’s say you're suing for sexual discrimination, and you were subject to unwanted touching and suffered bruises. This makes the situation very different. With pictures and a doctor’s testimony about the injury, significant damages could be allocated to the “physical” injury, and these damages would be beyond the reach of the Internal Revenue Service, just like the “physical injuries” in the preceding case.

Let’s say you negotiate a $1 million settlement on a sexual discrimination suit that involves some physical injuries. In the 39.6% tax bracket, that leaves you with $604,000 after-tax.

But if you structured the settlement for $250,000 for the discrimination, and $500,000 for the physical bruising, you would net, after tax, $651,000 — a gain of $47,000 more for you. The defendant would actually save $250,000.

Paying the Lawyers

The taxation of legal awards and settlements becomes even more complicated when you add in the legal fees.

Most lawyers (97%, according to the American Bar Association) in personal-injury cases work on a contingency basis. So, your lawyer gets paid only if you win, and his fee is a percentage of your award or settlement, averaging 18% and usually never exceeding 30% (again, according to the American Bar Association).

The courts are mixed on how to handle the fees. Some judges hold that the fees create a right of ownership — or attorney’s lien — for the lawyers. Since the lawyer owns that portion of the award, it’s not your asset and therefore shouldn’t be considered income that is taxable to you. This is the rule in the 5th, 6th and 11th federal circuits. That means the Deep South and Michigan, Ohio, Kentucky and Tennessee.

However, most courts, including the U.S. Tax Court, hold contingency fees to be a creditor’s right, a right to be paid by you, as the attorney’s client. In such cases, the entire award is included in your gross income, and is taxable.

Here's how important this distinction can be. Let's say you receive a taxable award of $1 million and have to give your lawyers 25%, or $250,000.

If your case is in a state where the fees create that lien we talked about, you’re only taxed on $750,000. However, in the second case, you’re taxed on the whole $1 million.

But how about a deduction for the $250,000 paid to your attorney?

Yes, you get the deduction, but only as a miscellaneous itemized deduction. So first, you have to itemize, which you might not have had to do in the original instance. More importantly, your miscellaneous itemized deductions must be reduced by 2% of your adjusted gross income. So, if you had no additional income (a very conservative assumption), you lose, at a minimum, at least 2% of $1 million, or $20,000 in deductions.

It doesn’t end there. The attorney gets taxed for the $250,000 you gave him, too. So, for your $250,000 fee for the attorney, IRS gets to tax, again at a minimum, $270,000!

Rewriting the Law

Congress may ultimately resolve these issues. In 2000, U.S. Rep. Deborah Pryce, R-Ohio, introduced a bill to clarify the situation. Her Civil Rights Tax Fairness Act had plenty of co-sponsors and some important features:

The bill is still bottled up in Congress. Until it is finally approved, a prudent taxpayer should insist on separate checks for fees and for the settlement . . . or move to a state in the more appropriate federal circuit.