Over the weekend I read a terrific article in Litigation, the Journal of the ABA’s Section of Litigation, called “Top Ten Tax Tenants for Trial Lawyers.“   (No, I usually don’t spend my weekends reading about tax policy, but I was out-of-town and had the magazine with me.)   The author, Robert W. Wood of Wood & Porter in San Francisco, did a nice job of summarizing issues to keep in mind when settling or trying cases, especially employment cases.  Among the things I learned (or was reminded of):

• Litigation recoveries, whether by settlement or or judgment, take their tax treatment from the origin and nature of the claim.   In other words, if the claim is for lost wages, any recovery will be taxed as wages, while a claim for lost profits will be treated and taxed as lost profits.   It is important, therefore, to have tax language in the settlement agreement that is consistent with the theory of the case.
• Section 104 of the Internal Revenue Code provides an income exclusion for recoveries by settlement or judgment for personal physical injuries or sickness.   Since 1996, the IRS has maintained that the exception is a limited one, and that the injury must be one that can be seen, like a broken bone.  (There is no case law on what constitutes a sickness).   If there is a legitimate physical injury, however, emotional distress damages flowing from that injury are also excludable.   This is a common source of contention between plaintiffs and defendants when settling a claim, and it is important to have researched and documented your position before the settlement conference or mediation.
• In employment cases, contingent-fee plaintiffs get an above-the-line deduction for legal fees that they paid.  Thus, if the settlement was for $100,000 and $40,000 of that went to the plaintiff’s attorney, the plaintiff only pays tax on the $60,000 that she receives even thought the entire $100,000 is treated as income to her.
• When settling a case, considering cutting separate checks to the plaintiff and her attorney.  The advantage is that the lawyer will get a 1099 only for the lawyer’s fee, although the plaintiff’s 1099 will reflect the entire settlement amount.    
• Anyone making payments in connection with a business must issue a 1099 for payments of $600 or more.   However, most lawyers do not issue 1099 to their clients for settlement proceeds initially deposited in the lawyer’s trust account on the theory that the lawyer is merely an intermediary.

As is always the case, especially when discussing an area I know nothing about like taxes, no one in their right mind should rely on the above as specific legal advice.  Instead, talk to someone who really knows this area.

taxes