The Special Needs Alliance asked Jeremy Babener to summarize a presentation on tax issues in personal injury cases that he made at the Society of Settlement Planners Annual Meeting in Las Vegas on May 6. Babener is a tax attorney at Lane Powell PC and regularly advises on tax issues relating to lawsuits, structured settlements and qualified settlement funds. You can find his bio and a list of his articles and bio here.
Personal injury claimants have many things to think about before settling a case. It often makes sense for claimants to prioritize non-tax over tax objectives (e.g., maintaining government benefits or avoiding premature dissipation). However, claimants should understand the tax consequences of their choices, and their advisors should ensure that they obtain any tax benefits that are available to them in light of their ultimate decisions.
Following are a few points that advisors to claimants sometimes miss when drafting settlement agreements:
- State and Substantiate. The tax treatment of lawsuit proceeds depends on the intent of the payor. Thus, the settlement agreement generally should state the payor’s reason for making the settlement payment. Since the IRS and courts do not always respect statements made in settlement agreements, it is best to include recitals of facts that substantiate the payor’s reason.
- Allocate and Substantiate. Some courts have held that if (1) any portion of a settlement payment is taxable and (2) the settlement agreement fails to demonstrate that a specific portion of the payment is nontaxable, 100 percent of the payment is taxable. Thus, a settlement agreement generally should state the specific amounts of a settlement payment that are made to compensate for particular injuries and include recitals of facts that substantiate the allocation.
- Watch Out for Nontaxable Emotional Distress Damages. Although damages for emotional distress generally are taxable, they may be nontaxable if (1) the claimant’s emotional distress resulted from the claimant’s physical injuries or physical sickness, or (2) the claimant’s emotional distress resulted from another person’s physical injuries or physical sickness, or (3) the damages compensate the claimant for expected medical expenses (e.g., psychologist fees), or possibly (4) the emotional distress was so significant that it caused physical ailments observable by a doctor (e.g., a heart attack).
- Avoid that 1099. Some courts have relied on a payor’s reporting of a settlement payment on Form 1099-MISC as a basis for holding that the payment was taxable. Thus, a settlement agreement generally should include a provision that prohibits the payor from issuing a Form 1099-MISC with respect to damages that the claimant believes to be nontaxable.
Following are a few types of tax that advisors may miss when they are considering the impact of a lump sum versus a structured settlement:
- The Alternative Minimum Tax (the “AMT”). Legal fees of personal injury claimants are often subject to the limitations applicable to miscellaneous itemized deductions. Perhaps the most dramatic of these is that miscellaneous itemized deductions are disallowed in computing a taxpayer’s AMT liability. Thus, if a personal injury plaintiff receives a large taxable lump sum award or settlement, she may be unable to offset that taxable income by deducting her legal fees. Receiving the taxable proceeds over many years (i.e., through a “structured settlement”) can reduce her taxable income in each year so that she can avoid the effect of the AMT.
- The Net Investment Income Tax (the “NIT”). Damages are sometimes nontaxable, but earnings from investing those proceeds usually are taxable. A claimant can indirectly invest those proceeds tax-free by agreeing to receive them over many years, plus some additional amount in exchange for the delay in payment (i.e., entering into a “structured settlement”). Doing so can avoid the income tax (which is now imposed at a maximum rate of 39.6% on interest income and 20% on capital gains and dividends) and the NIT. The NIT is a 3.8 percent tax imposed on passive income earned by individuals and trusts meeting certain criteria. The NIT applies to the lesser of (1) an individual taxpayer’s net investment income and (2) the excess of the taxpayer’s adjusted gross income over the “threshold amount” ($200,000 for single individuals and $250,000 for joint returns). Thus, a single individual with $300,000 of adjusted gross income and $50,000 of net investment income owes NIT liability of $1,900 ($50,000 x 3.8percent). A single individual with $200,000 of adjusted gross income and $50,000 of passive income owes no NIT liability because the adjusted gross income does not exceed the threshold amount of $200,000.
- The Kiddie Tax. Under the Kiddie Tax, a young claimant’s taxable lawsuit proceeds or taxable earnings from the investment of lawsuit proceeds may be subject to the tax rate of the claimant’s parents. The Kiddie Tax generally applies to passive income in excess of $2,000 earned by a child who does not file a joint return, has at least one living parent (natural or adoptive), and (1) is under 18, (2) became 18 in the given tax year and earned non-passive income constituting 50 percent or less of her support, or (3) is 19 to 23, earned non-passive income constituting 50 percent or less of her support, and is a full-time student for at least five months of the year. A claimant whose income is subject to the Kiddie Tax and whose parents are subject to tax at high rates should consider delaying her settlement or agreeing to receive her lawsuit proceeds in years when the Kiddie Tax will not apply (i.e., entering into a structured settlement).
No time in a case is too early to be thinking about tax consequences. Even the selection of claims alleged in a demand letter or complaint can place a claimant in a better or worse position tax-wise.