Refresher on Tax Treatment of Employment-Related Judgments & Settlements
Tax lawyers are a separate species from the rest of us, so pardon my foolish attempt at entering the no-man's land otherwise known as the Internal Revenue Code (IRC). Frankly, the safest course for all of us is to read the fairly recent 20-page Income and Employment Tax Consequences and Proper Reporting of Employment-Related Judgments and Settlements (download) memorandum published by the Office of Chief Counsel, Internal Revenue Service.
As thoroughly examined and explained in that memo, the correct treatment of employment-related settlement payments is a four-step process:
1. Character of the Payment. Determine the character of the payment and the nature of the claim that gave rise to the payment. For example, a payment could be for a lost wages claim brought under Title VII of the Civil Rights Act of 1964.
2. Is Payment Included in Gross Income? Determine whether the payment constitutes an item of gross income.
3. Is Payment Considered Wages? Determine whether the payment is wages for employment tax purposes (Federal Insurance Contributions Act (FICA), and income tax withholding).
4. Reporting. Determine the appropriate reporting for the payment and any attorneys’ fees (Form 1099 or Form W-2).
Answers and guidance on practically all of the scenarios that usually arise are contained in charts at pages 15 through 20 of the memo.
Compensatory Damages Due to Physical Injuries or Sickness
Perhaps one of the more frequently arising questions is the tax treatment of judgments or settlements for compensatory damages associated with emotional distress and pain and suffering that are often claimed by plaintiffs in employment discrimination cases.
Section 104(a)(2) of the IRC, which excludes compensatory damages received “on account of personal physical injuries or physical sickness” from the definition of taxable gross income, expressly states that “emotional distress shall not be treated as a physical injury or physical sickness” for purposes of this exclusion. Therefore, the IRS and many courts interpreting the IRC have taken the position that a settlement payment (or judgment) for the intangible value of an emotional distress claim (i.e. claims unrelated to a physical injury or physical sickness) is taxable income.
In addition to pages 5 and 6 of the memo, a user-friendly overview of when distress related to a physical injury is excludable under IRC 104(a)(2) is cogently explained by the U.S. Tax Court in Moulton v. Commissioner, No. 4552-06, T.C. 2009-38 (Feb. 18, 2009) (download).
In Moulton, the Tax Court ruled that a $65,000 settlement payment to an employee claiming wrongful termination was includable in gross income even though the claimant alleged mental injuries as a result of the job loss. The Court held:
To the extent petitioner may have suffered depression, sleep disorders, or elevated blood sugar levels that he attributed to heightened stress from his job termination and its aftermath, those conditions fall within the category of 'emotional distress' that 'shall not be treated as a physical injury or physical sickness' for purposes of the exclusion provided in section 104(a)(2).
It would be interesting to see how the Tax Court would have ruled had the claim of distress been more severe and associated with a neurophysiologic disorder of the brain and more akin to a biological disease with inherent physical manifestations. According to the memo, however, the IRS's "administrative position is that observable or documented bodily harm, such as bruising, cuts, swelling or bleeding is evidence of personal physical injury. . . . Damages recovered from an employment-related dispute generally are not recoveries for a personal physical injury. Thus, employment-related judgment/settlement amounts will generally be included in the employee’s gross income."
All of this, of course, means that the tax aspects of settlements need to be carefully addressed with combined advice of tax counsel and employment law counsel during negotiations between the parties.
