In litigation, a little tax planning pays off
The economic impact of a settlement or damages award depends on whether it’s taxable to the plaintiff and deductible by the defendant. A tax-free $1 million judgment, for example, is substantially more valuable to a plaintiff than one that comes with a $400,000 tax bill. And from a defendant’s perspective, the ability to deduct a damages payment takes some of the sting out of a loss. By incorporating tax strategies into the litigation planning process, you can help your clients improve their chances of a tax-beneficial outcome.
Deductibility of damages in FCA cases
In a 2014 case — Fresenius Medical Care Holdings Inc. — the U.S. Court of Appeals for the First Circuit opened the door to greater deductibility of damages in False Claims Act (FCA) settlements, upholding a defendant’s $50 million refund claim. The defendant argued that a significant portion of double damages paid to the government were compensatory rather than punitive in nature and, therefore, deductible. Departing from an earlier Ninth Circuit case, the First Circuit held that a court may consider factors beyond the mere presence or absence of a tax characterization agreement between the parties in determining whether settlement payments are deductible.
To improve their chances of a tax-beneficial outcome, defendants in FCA cases should document their settlement discussions with the government and gather evidence that demonstrates the compensatory nature of damages.
How are damages taxed?
Generally, a plaintiff’s recovery of damages is taxable unless a specific exception applies. In addition to income taxes, damages that represent wages, such as back pay in employment discrimination cases, are also subject to FICA and other employment taxes.
One exception is an award that produces no gain for a plaintiff. This might include an award that reimburses a plaintiff for nondeductible expenses or for damage to, or destruction of, a capital asset, such as real property or stock. In the case of a capital asset, damages are tax-free up to the plaintiff’s adjusted basis in the property. To the extent that damages exceed the plaintiff’s basis, they’re taxable as capital gains.
Another exception is compensation for injuries or sickness excludable from income under Internal Revenue Code Section 104. This includes compensatory damages received “on account of personal physical injuries or physical sickness” under Sec. 104(a)(2). The application of Sec. 104(a)(2) is straightforward in cases involving bodily injury.
Suppose, for example, that Martha is seriously injured in a car accident caused by the defendant’s negligence, and recovers damages for medical expenses, pain and suffering, lost wages and emotional distress. Arguably, all of these damages, which flow from the original bodily injury, are tax-free because they’re “on account of personal physical injuries.”
Things get more complicated in cases involving nonphysical injuries that result in physical injury or physical sickness. Employment discrimination cases, for example, often have a significant emotional distress component that may lead to serious physical illness. But Sec. 104 expressly states that emotional distress shall not be treated as a physical injury or physical sickness (except for medical expenses).
The IRS and courts generally don’t apply this exclusion to damages attributable to emotional distress symptoms, such as migraines, nausea or insomnia. But some courts have held that damages for emotional distress are tax-free when it causes more serious physical harm, such as a heart attack or nerve damage, and the plaintiff’s condition is supported by a medical diagnosis and testimony.
When are damages deductible?
The deductibility of a defendant’s payment of damages doesn’t depend on whether they are includable in the plaintiff’s income, but it generally follows the same rules that govern the deductibility of other expenses. For example, damages that constitute “ordinary and necessary business expenses” are deductible, while payments associated with personal litigation are not. A deduction is not available for punitive damages, fines and penalties, or statutory treble damages.
In some cases, defendants are required to capitalize, rather than deduct, damages payments and recover their costs through depreciation or amortization. For example, in litigation involving the breach of a contract to acquire a capital asset, the defendant may have to add its litigation costs to the property’s basis.
Laying the foundation
Tax planning early in a case can help lay the foundation for a beneficial tax outcome. Many cases involve a combination of taxable and nontaxable (or deductible and nondeductible) claims, so the tax treatment of a judgment or settlement depends on how it’s allocated among those claims. Whether damages are allocated by the court or by the parties in their settlement agreement, the allocation must have economic substance.
For example, suppose Martha and her employer settle an employment discrimination claim for $1 million and the settlement agreement allocates $200,000 to back pay and the remaining $800,000 to serious physical injury caused by emotional distress. A court is unlikely to uphold this allocation unless Martha emphasized physical injuries in her complaint or in correspondence with her employer, received medical treatment for those injuries and offered medical evidence in support of her claim.
Best economic outcome
When formulating litigation strategies, taxes may not be your top priority. But considering taxes early in a case can help you achieve the best economic outcome for your client.
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