The federal tax treatment of litigation settlements or judgments and related legal fees can have a significant impact on the net value of a settlement or award. Ideally, tax consequences should be considered from day one of the litigation process. While proper planning can make a good settlement better, failure to adequately plan can transform an otherwise good settlement into a bad one or make a bad settlement even worse.

Three Categories of claims

It is essential to consider the origin and nature of the underlying legal claim when ascertaining the taxability of a payment made pursuant to a settlement or judgment. The origin of the claim can be established by reviewing the complaint, the history of negotiations and the settlement agreement (if applicable). However, in most cases the complaint will be the most relevant evidence for how payments should be characterized and illustrates why tax consequences should be considered from the start.

Although every circumstance is unique, settlements and judgments generally fall into the following main categories: personal injury claims, discrimination and other employment related claims and other non-personal injury claims.

Personal injury claims

Payments received from personal physical injury or physical sickness claims are excluded from gross income. In general, all damages flowing from a physical personal injury are excludible from gross income. Emotional distress is not considered a physical injury or sickness, however, if it arises from a personal physical injury or sickness, it is excludible.

Personal injury awards that include both compensatory and punitive portions do not qualify for the full income exclusion. Only the compensatory component is excludable, while the punitive damages piece is included in gross income. Additionally, the exclusion is unavailable to the extent the payments received are attributable to medical expenses previously deducted.

Discrimination and other employment related claims

In the past decade, this area of the tax law has become extremely simplified and virtually all employment related proceeds are fully taxable, including discrimination awards. But amounts received to replace what would have been nontaxable fringe benefits are generally nontaxable. Additionally, in the rare case that an employment recovery is paid on account of personal physical injuries or physical sickness it is excluded from gross income.

The most significant issue associated with these claims is the allocation of a settlement between taxable wages and taxable nonwage recoveries. This is an important issue because it has the potential to make tremendous differences in a taxpayer's ultimate recovery. Severance and back pay awards are almost always considered taxable wages and are thus subject to employment taxes on top of income tax. While the allocation issue is complex and uncertain and the safest approach may be to treat all settlements in the employment context as wages, this is over-inclusive. If all or a portion of the proceeds are truly related to a tort settlement, no employment taxes should be withheld.

Other non-personal injury claims

Generally, payments received pursuant to a settlement or judgment for non-personal injury claims are included in gross income. The question that usually arises in these cases is whether such amounts are characterized as ordinary income, return of capital or capital gain. Again, it is the origin of the claim that is the determinative factor.

Deductibility of Legal Fees

Business taxpayers

Since there are a multitude of situations where sizeable legal fees are incurred, the determination of their deductibility is essential. For business taxpayers to deduct legal fees the fees must be: (i) incurred in carrying on a trade or business; (ii) ordinary and necessary; (iii) reasonable in amount; (iv) paid or incurred during the taxable year in which the taxpayer seeks to deduct them; and (v) paid by the person to whom the services are rendered.

Personal legal fees

Although the Internal Revenue Code specifically allows a deduction for certain personal expenses (e.g., alimony, charitable contributions, etc.), as a general rule, expenditures that are strictly personal are not deductible (e.g. will preparation, fighting traffic ticket, etc.). Legal fees which might otherwise appear to be nondeductible, are in fact deductible if they are (i) paid or incurred for the production or collection of income, (ii) paid or incurred for the management, conservation, or maintenance of property held for the production of income, or (iii) paid or incurred in connection with the determination, collection, or refund of any tax.

If the transaction in which the legal fees incurred is partially attributable to one of the above categories, the taxpayer must allocate the fees between the deductible and non-deductible portion. The deductible portion of legal fees is deductible as a miscellaneous itemized deduction to the extent they exceed 2 percent of adjusted gross income (AGI). They are also subject to an overall limitation on itemized deductions and are not allowed in computing alternative minimum tax (AMT).

For example, legal fees incurred in a divorce proceeding to dissolve a marital relationship clearly originate from a claim that is personal in nature, and such fees are generally nondeductible personal expenditures. However, the portion of legal fees attributable to the production or collection of taxable alimony is deductible by the recipient of the alimony as a nonbusiness expense. Similarly, legal fees paid or incurred in the acquisition or disposition of, or in perfecting title to, property originate from a claim that is capital in nature, and must be capitalized.

Personal injury claims

The legal fees and court costs incurred for claims that are incorporated entirely within this exclusion are not deductible, since the legal fees incurred generated nontaxable income. To the extent a personal injury award is allocated to punitive damages the legal fees are deductible on a pro rata basis as a miscellaneous itemized deduction to the extent they exceed 2 percent of AGI. They are also subject to an overall limitation on itemized deductions and are not allowed in computing AMT.

Discrimination claims

There is an exception to the classification of deductible personal legal fees as a miscellaneous itemized deduction. Taxpayers are allowed an "above-the-line" deduction for attorney fees and court costs paid in connection with discrimination suits. This circumvents the 2 percent of AGI floor limitation and the overall 3 percent limitation on itemized deductions. It is also allowed in computing AMT. However, there is one limitation. The deduction cannot exceed the amount includible in income for the year on account of a discrimination judgment or settlement.

Legal fees paid directly to counsel

This category generally includes claims falling under either fee-shifting statutes, where the court awards legal fees directly to counsel, or qualified settlement funds (QSF) covered by Treasury Reg. Section 1.468B-4. Claims paid under either fee-shifting statutes or by QSF include securities claims and non-personal injury product liability and business practice class actions with numerous plaintiffs. Since the majority of securities and other class action cases result in the establishment of a QSF, from which legal fees are paid directly, only the net amount distributed to claimants is includible in gross income under the applicable regulations. Consequently, for claims in this category, the contingent legal fees are effectively deducted "above-the-line" by operation of the relevant Treasury regulation.

Minimizing the Tax Impact of Settlements

The above discussion only touches the surface of the many issues involved in determining the taxability of litigation proceeds and deductibility of related legal fees. However, because there may be substantial opportunities to influence or structure the tax impact of most settlements, it is prudent to consider and/or seek the advice of a tax professional when dealing with these situations.

Michael A. Gillen is the director of the tax accounting group of Duane Morris, a group of certified public accountants providing tax, accounting and consulting services as an ancillary business of the law firm, where he devotes his practice to federal, state and local income taxation. He is a former two-term president of the Greater Philadelphia Chapter of the Pennsylvania Institute of Certified Public Accountants and is a published author and speaker regarding tax and litigation consulting topics.

Barbara A. Ruth is a senior manager in the tax accounting group of Duane Morris, where she devotes her practice to federal, state and local taxation. She is a member of the Philadelphia Bar Association's committee on women in the profession and its state and local tax committee, and she is a speaker at tax-related programs.

As required by United States Treasury Regulations, you should be aware that this communication is not intended by the sender to be used, and it cannot be used, for the purpose of avoiding penalties under United States federal tax laws.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.