Taxable Settlement Payment

[ruthc]

Client received a cash settlement. She wouldn't explain details due to agreement not to speak about the case after settlement, but she said it has nothing to do with wages or physical damages. I told her it would help to know the background in order to make the correct decision on whether it is taxable or not. Right now I am going with her term "emotional distress". I think it may pertain to some type of personal injury (like reputation got damaged in some way).

The award was only $19K. She received $15K after lawyer fees. After researching, I believe the amount is taxable. I am just not sure if the whole $19K is taxable or just the $15K. I thought the total would be taxable and the lawyer's fees would not be deductible anymore due to the new tax rules. The check went to the lawyer and he sent her the $15K. I think she should receive a 1099M for the correct amount, but how would that work if the check for the total amount was originally made out and sent to the lawyer. If the check was made out to the lawyer, and he then gives her the $15K, would she receive a 1099M from the lawyer for the total or what she received?

Would the taxable amount be included on Schedule 1, Addtl Income, Line 21 Other Income?

I would appreciate any help anyone has regarding how this would work.

[TAXNJ]

See The TaxBook 3-17

Emotional distress. Damages for emotional distress are taxable if not caused by physical injury or sickness. Damages are taxable even if the emotional distress causes physical symptoms.
Exception: Damages up to the cost of deductible medical care under IRC section 213 are excluded from income. (Pettit, T.C. Memo 2008-87

Legal fees and court costs. For tax years 2018 through 2025, miscellaneous itemized deductions subject to the 2% AGI limitation are not allowed. Therefore, most legal fees and court
costs cannot be deducted. These costs cannot be netted against the settlement.

[ruthc]

Thanks for the response, but I did had read the above from Pub 17. I still have the same questions I listed. Would the total award be taxable or just the amount she was paid by the lawyer. Also, would it be listed as "other income" on the 1040 form.

[TAXNJ]

Thanks for the response, but I did had read the above from Pub 17. I still have the same questions I listed. Would the total award be taxable or just the amount she was paid by the lawyer. Also, would it be listed as "other income" on the 1040 form.

If you are referencing the IRS publications, then you need to look further on the IRS website

https://www.irs.gov/pub/irs-pdf/p4345.pdf

[ruthc]

If you are referencing the IRS publications, then you need to look further on the IRS website

https://www.irs.gov/pub/irs-pdf/p4345.pdf

Thank you for the additional info. I will definitely read further. I found out the facts of the case from the lawyer. Would it be ok to state some facts without mentioning names to get more help later? I don't want to do anything unethical.

[spanel]

Thanks for the response, but I did had read the above from Pub 17. I still have the same questions I listed. Would the total award be taxable or just the amount she was paid by the lawyer. Also, would it be listed as "other income" on the 1040 form.

Total amount ($19000) and yes, other income.

Chris

[ruthc]

I finished reading Pub 4345. A lot info to absorb. I finally got some info from the lawyer. Below is the info he gave me. After reading the below my mind is changing from taxable to non-taxable.

The client had a claim for negligence by the PD in taking her into so-called protective custody (getting drunk on News' Year Eve). Her claim was for personal injury.

He wrote "There was no judgment in her case. She had a claim for negligence by the PD in taking her into so-called protective custody. Her claim was for personal injury. He wrote (I saw in Pub 525) that "Damages are taxable when obtained for emotional distress that did not arise from some form of wrongful physical conduct, such as discrimination. Here the client's injuries arose from wrongful physical conduct (locking her up overnight). Her damages are not for emotional distress but for physical and mental pain and suffering. Physical and mental suffering, which under the law is a very different animal than emotional distress. Emotional distress is a mental condition that may be caused by physical injury (such as a car accident or an assault leading to PTSD) or by non-physical conduct like discrimination. The client's successful claim was not for emotional distress, but for physical pain and suffering arising from physical misconduct. To be sure, she was not physically assaulted, but under the law wrongfully confining a person is physical injury per se." He also noted that there was no punitive damages. It was only compensatory.

After reading the above does anyone feel the same as I do, that the money would not be taxable?

[JohnH]

I've only seen two of these types of settlement over the years. Both were sexual harassment claims. In both cases, the wording permitted the wronged party to share the actual settlement document with certain parties. Their tax preparer was specifically listed as one of those parties. I assume this was the way the lawyers who drew up the settlements absolved themselves of any responsibility for making any determination regarding taxability.

If this were my client, I'd probably tell them to look carefully at the settlement document and see if there's wording allowing them to show it to me. If they say there isn't, or if they otherwise refuse to show it to me, then I'd likely tell them the $19K will need to be considered taxable income because I have no documented reason to report it in any other manner. (What they say is says isn't good enough.)

I don't really want to know the details, but their situation demands it if they want me to find out if any or all of the settlement might be excluded from income. If they aren't happy with that, then their next tax preparer will have to make their own decision on how to handle it because I won't be preparing the return.

[Burke]

If this were my client, I'd probably tell them to look carefully at the settlement document and see if there's wording allowing them to show it to me. If they say there isn't, or if they otherwise refuse to show it to me, then I'd likely tell them the $19K will need to be considered taxable income because I have no documented reason to report it in any other manner. (What they say is says isn't good enough.)

I agree with this. I would want to see the settlement document myself.

[New York Enrolled Agent]

Below is the info he gave me. After reading the below my mind is changing from taxable to non-taxable.

The client had a claim for negligence by the PD in taking her into so-called protective custody (getting drunk on News' Year Eve). Her claim was for personal injury.

He wrote "There was no judgment in her case. She had a claim for negligence by the PD in taking her into so-called protective custody. Her claim was for personal injury. discrimination. The client's successful claim was not for emotional distress, but for physical pain and suffering arising from physical misconduct. To be sure, she was not physically assaulted, but under the law wrongfully confining a person is physical injury per se." He also noted that there was no punitive damages. It was only compensatory.

After reading the above does anyone feel the same as I do, that the money would not be taxable?

As has been said by others, you must assume the award is taxable unless there is a statutory exception. IRC §104(a)(2) is quite clear - there must be physical injury or sickness. I would ask the attorney to give you a cite that confirms the bold red statement. In the absence of physical injury the award is taxable.

In two instances in your post, it is alleged the claim was for personal injury - that is not sufficient for non-taxable treatment.

[ruthc]

As has been said by others, you must assume the award is taxable unless there is a statutory exception. IRC §104(a)(2) is quite clear - there must be physical injury or sickness. I would ask the attorney to give you a cite that confirms the bold red statement. In the absence of physical injury the award is taxable.

In two instances in your post, it is alleged the claim was for personal injury - that is not sufficient for non-taxable treatment.

Thanks for more info on this. After questioning her lawyer again he wrote: "There was no judgment or award because the case was settled by agreement without trial. As is customary, the check was payable to both xxxx and my partner, xxxx. It was deposited in our client funds holding account and she received a check for her net recovery from that account. We did not issue a 1099 to her and neither did the city of xxxx. Typically when a suit is settled we receive a 1099 for the entire amount; I find no 1099 for this settlement in our system".

He continued: "I think one confusing issue here is the distinction between a claim for emotional distress resulting from physical injury (proceeds not taxable) versus emotional distress resulting from non-physical misconduct (proceeds taxable). xxxx's arrest and confinement were physical acts that fit the legal definition of assault and battery. (ANY intentional touching of a person without her consent is a battery.) They caused her physical injury and discomfort -- fortunately transient but real nevertheless."

"The other confusing issue, which I hope we've tried to address, is physical and mental pain and suffering versus emotional distress. For various reasons, including potential tax complications, we did not pursue a claim for emotional distress. But even if this recovery were considered to be for emotional distress, it was distress resulting from physical restraint and injury,"

I don't know how the 1099's work for these settlements, but I have always found the 1099's sent to everyone after the year ends. Not being a lawyer, I would like to know if it is customary for payer to send the 1099s before the year ends. I get the impression from his statement that he doesn't expect her or his firm to receive a 1099 because he hasn't received it yet. Do you know if this is customary? I know the check was made out to both of them and listed her social security number. I think she should get a 1099 for the total $19K.

[New York Enrolled Agent]

"There was no judgment or award because the case was settled by agreement without trial.

He continued: "I think one confusing issue here is the distinction between a claim for emotional distress resulting from physical injury (proceeds not taxable) versus emotional distress resulting from non-physical misconduct (proceeds taxable). xxxx's arrest and confinement were physical acts that fit the legal definition of assault and battery. (ANY intentional touching of a person without her consent is a battery.) They caused her physical injury and discomfort -- fortunately transient but real nevertheless."

Ruth - I would urge you to read the settlement document - if the lawyer says you can't then disengage.

There is no clear answer here - some may argue as the lawyer has. However, that doesn't mean it is automatically correct. The settlement document should state the nature of the claim and the settlement should reflect the outcome. Like most questions, it's always facts and circumstances. There is no definition of "physical injury or sickness". The IRS position has evolved from the so-called "bruise rule" but there still needs to be physical injury.

The Tax Court has offered at least one opinion where the conclusion is contrary to the attorney in this case. You need to read the whole case but I will paste a snip. Stadnyl TCM 2008-289. See if these facts are close to what you have.

Physical restraint and physical detention are not "physical injuries" for purposes of section 104(a)(2). Being subjected to police arrest procedures may cause physical discomfort. However, being handcuffed or searched is not a physical injury for purposes of section 104(a)(2). Nor is the deprivation of personal freedom a physical injury for purposes of section 104(a)(2). Physical injury is not required for the tort of false imprisonment to occur. Kentucky courts define false imprisonment as "any deprivation of the liberty of one person by another or detention for however short a time without such person's consent and against his will, whether done by actual violence, threats or otherwise." Grayson Variety Store, Inc. v. Shaffer, 402 S.W.2d 424, 425 (Ky. Ct. App. 1966). The tort of false imprisonment protects personal interest in freedom from physical restraint; such an interest is "in a sense a mental one". Banks v. Fritsch, 39 S.W.3d 474, 479-480 (Ky. Ct. App. 2001). Injury from false imprisonment is "in large part a mental one" where the plaintiff can recover for mental suffering and humiliation. Id. at 479. The alleged false imprisonment against petitioner wife did not cause her to suffer physical injury as required for relief under section 104(a)(2).

[ruthc]

Ruth - I would urge you to read the settlement document - if the lawyer says you can't then disengage.

There is no clear answer here - some may argue as the lawyer has. However, that doesn't mean it is automatically correct. The settlement document should state the nature of the claim and the settlement should reflect the outcome. Like most questions, it's always facts and circumstances. There is no definition of "physical injury or sickness". The IRS position has evolved from the so-called "bruise rule" but there still needs to be physical injury.

The Tax Court has offered at least one opinion where the conclusion is contrary to the attorney in this case. You need to read the whole case but I will paste a snip. Stadnyl TCM 2008-289. See if these facts are close to what you have.

Physical restraint and physical detention are not "physical injuries" for purposes of section 104(a)(2). Being subjected to police arrest procedures may cause physical discomfort. However, being handcuffed or searched is not a physical injury for purposes of section 104(a)(2). Nor is the deprivation of personal freedom a physical injury for purposes of section 104(a)(2). Physical injury is not required for the tort of false imprisonment to occur. Kentucky courts define false imprisonment as "any deprivation of the liberty of one person by another or detention for however short a time without such person's consent and against his will, whether done by actual violence, threats or otherwise." Grayson Variety Store, Inc. v. Shaffer, 402 S.W.2d 424, 425 (Ky. Ct. App. 1966). The tort of false imprisonment protects personal interest in freedom from physical restraint; such an interest is "in a sense a mental one". Banks v. Fritsch, 39 S.W.3d 474, 479-480 (Ky. Ct. App. 2001). Injury from false imprisonment is "in large part a mental one" where the plaintiff can recover for mental suffering and humiliation. Id. at 479. The alleged false imprisonment against petitioner wife did not cause her to suffer physical injury as required for relief under section 104(a)(2).

Thank you very much. I will ask him to read that info. I think at this point it may be a benefit to the client and myself to refer her to another preparer that is more experienced with these issues.

[JohnH]

The lawyer gets to speculate all sorts of fanciful things about the taxability of the settlement without any concern for risk, because his/her signature isn't going on the return. You (and the client) don't enjoy that same luxury.

[TAXNJ]

At this point, you might consider consulting with a Tax Attorney