Is lawsuit settlement award paid a tax deductible expense?

[Deborah]

Client is an LLC taxed as a partnership. A restaurant. Husband and wife are the only LLC members. The LLC and the wife were sued by a former employee. Client is going to settle rather than litigate and wants to know if the settlement award they pay to the former employee is tax deductible. I have not found anything in my research other than settlement awards received and litigation costs. Thanks.

[Uncle Sam]

Lawsuit Settlement

The answer to that is really determined on what the suit is based on?
If for past compensation - then it would be - as the compensation would have been deductible had the suit not taken place.
If for punitive damages - I believe not.

Anyway - doesn't the client have liability insurance? Is it going to pay out of their current operating funds?

[Deborah]

more on lawsuit settlement

The client does have insurance but they told me the insurance company would not pay the entire claim.

I told the client I needed to know what the nature of the lawsuit before I could comment on tax deductibility of the settlement award - but they still have not told me and their attorney has now contacted me (with their permission).

If the suit is for unfair or unpaid wages, that portion of any settlement would be treated as and taxed as payroll and paid through the company.
If it is for discrimination I would think not but can't find any authority on this.
And then it will depend if the LLC is the only remaining party of if the wife is still a party individually.

The client is planning on cashing in IRA accounts to pay whatever settlement the insurance won't cover which I really don't understand since they are an LLC.

So bottom line is that you agree with what I have researched so far - discrimination is punitive damages and not tax deductible, wages are a different story.

Thanks for your help. If you have any reference for the punitive damages, I would be most grateful.

Deborah

[geekgirldany]

I found this through google. Appears to be from FindLaw:

http://earthlink.findlaw.com/employmentbook/HFCHP9_e.html

There is an example in there about discrimination. It talks more about how to structure the settlement. I hope it helps you some.

[veritas]

Guess we know now

what the liabilty protection afforded by an LLC is.

I can't think of a reason why the settlement would not be deductible.

[Deborah]

Find Law reference

Thank you - very helpful.

[New York Enrolled Agent]

This discussion from TC Memo 2004-45 might be helpful???

As to the portion of the payment pertaining to the settlement of litigation, payments made to settle litigation are deductible as ordinary and necessary business expenses when they have business origin and otherwise satisfy the mandates of section 162(a). Anchor Coupling Co. v. United States, 427 F.2d 429 [25 AFTR 2d 70-1282] (7th Cir. 1970); Eisler v. Commissioner, 59 T.C. 634 (1973); Old Town Corp. v. Commissioner, 37 T.C. 845 (1962); Oliver v. Commissioner, T.C. Memo. 1997-84 [1997 RIA TC Memo ¶97,084]. A settlement payment has business origin when the transaction or activity causing the litigation originates in a trade or business; the potential consequences of a failure to prosecute or defend the litigation are secondary. See Woodward v. Commissioner, 397 U.S. 572, 577 [25 AFTR 2d 70-964] (1970); United States v. Gilmore, 372 U.S. 39, 44-51 [11 AFTR 2d 758] (1963); Wells Fargo & Co. v. Commissioner, supra at 887; Anchor Coupling Co. v. United States, supra at 433. The courts have created three independent tests which are helpful to determine whether a settlement payment with a business origin is deductible. These tests are (1) whether the taxpayer/payor lacked confidence that it would have prevailed in the lawsuit if it was not settled, (2) whether the taxpayer/payor made the payment to avoid damages or liability which might have resulted in the absence of the settlement, and (3) whether the belief held by the taxpayer/payor concerning the validity of the claim against him or her was justified to the extent that a reasonable person in his or her place would have thought that settlement was necessary. Old Town Corp. v. Commissioner, supra at 858-859. An answer in the affirmative to any of these tests tends to establish that the settlement payment is deductible under section 162(a).

[Corduroy Frog]

Non-Sequitur

I submit that some of these posts indicate there is a relationship between the deductibility of legal fees and the taxable income assessable to the awarded party. I believe we are going down the wrong path here.

Taxability, or exemption, of an award to one party does not create a respective deduction or non-deductible event for the payer. If this happens with punitive damages, I believe this to be a coincidence and not a result of "pass-through" mentality.

Rather, I would suggest that we look at three "tiers" of deductibility, e.g.
a) Business purpose, fully deductible against business operations
b) Defense of income-producing property, deductible on Schedule A, subject to 2%
c) Non-deductible, such as legal costs associated with a divorce.

The most advantageous of these would, of course, be a) above. An exposition of what constitutes a business purpose is presented quite excellently on the NYEA post above.