Editor: Christine M. Turgeon, CPA
During the normal course of business, a taxpayer may find itself the recipient or payer of a settlement or judgment as a result of litigation or arbitration. The federal tax implications of a settlement or judgment, which can be significant, often are overlooked.
For both the payer and the recipient, the terms of a settlement or judgment may affect whether a payment is deductible or nondeductible, taxable or nontaxable, and its character (i.e., capital or ordinary). In general, the taxpayer has the burden of proof for the tax treatment and characterization of a litigation payment, which generally will be determined by the language found in the underlying litigation documents, such as pleadings or a judgment or settlement agreement. Taxpayers should consider these issues during a litigation or arbitration process.
While the federal tax treatment does not depend on whether litigation is concluded by a judgment or order or by agreement of the parties, generally more flexibility exists in clarifying the proper tax characterization of an item when litigation is concluded by settlement rather than judgment, because of a greater ability to clearly reflect the intent of the parties and the purpose for the payment in a settlement agreement.
Origin of the claim
In general, the proper tax treatment of a recovery or payment from a settlement or judgment is determined by the origin of the claim. In applying the origin-of-the-claim test, some courts have asked the question "In lieu of what were the damages awarded?" to determine the proper characterization (see, e.g., Raytheon Prod. Corp., 144 F.2d 110 (1st Cir. 1944)).
For a recipient of a settlement amount, the origin-of-the-claim test determines whether the payment is taxable or nontaxable and, if taxable, whether ordinary or capital gain treatment is appropriate. In general, damages received as a result of a settlement or judgment are taxable to the recipient. However, certain damages may be excludable from income if they represent, for example, gifts or inheritances, payment for personal physical injuries, certain disaster relief payments, amounts for which the taxpayer previously received no tax benefit, cost reimbursements, recovery of capital, or purchase price adjustments. Damages generally are taxable as ordinary income if the payment relates to a claim for lost profits, but they may be characterized as capital gain (to the extent the damages exceed basis) if the underlying claim is for damage to a capital asset.
For the payer, the origin-of-the-claim test determines whether the payment is deductible or nondeductible, currently deductible, or required to be capitalized. For example, a claim for damages arising from a personal transaction may be a nondeductible personal expense. A payment arising from a business activity may be deductible under Sec. 162, while payments for interest, taxes, or certain losses may be deductible under specific provisions of the Code (e.g., Sec. 163, 164, or 165). Certain payments are nondeductible (as explained further below), and others must be capitalized, such as when the payer obtains an intangible asset or license as a result of a settlement.
The burden of proof generally is on the taxpayer to establish the proper tax treatment. Types of evidence that may be considered include legal filings, the terms of the settlement agreement, correspondence between the parties, internal memos, press releases, annual reports, and news publications. However, as a general rule, the IRS views the initial complaint as most persuasive (see Rev. Rul. 85-98).
Allocation of damages
When a payment for a settlement or judgment encompasses more than one claim, a taxpayer must determine how the payment should be allocated. Allocation issues also may arise when there are multiple plaintiffs or defendants. Relevant factors to consider in determining an allocation may include:
- Who made and received the payment?
- Who was economically harmed or benefited?
- Against whom were the allegations asserted?
- Who controlled the litigation?
- Were costs/revenue contractually required to be shared?
- Is there joint and several liability?
A settlement or judgment may provide for an allocation. An allocation in a formal judgment generally binds both the IRS and the taxpayers. The IRS generally accepts an allocation in a settlement agreement unless the facts and circumstances indicate a taxpayer has another purpose for the allocation. The taxpayer has the burden of defending the allocation in a proceeding with the IRS.
The Code disallows deductions for certain payments and liabilities resulting from a judgment or settlement.
As amended by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, Sec. 162(f) disallows deductions under any provision of Chapter 1 for amounts paid or incurred (1) by suit, agreement, or otherwise; (2) to or at the direction of a government or governmental entity; and (3) in relation to a violation of law or an investigation or inquiry into a potential violation of law. The disallowance does not apply to payments for restitution (including remediation of property) or to come into compliance with law; taxes due; or amounts paid under court orders when no government or governmental entity is a party to the suit. Recently published final regulations clarify that the disallowance also does not apply to proceedings involving the government enforcing its rights as a private party — for example, a contract action — or to routine audits or inspections not related to possible wrongdoing (T.D. 9946).
The restitution exception applies only if (1) a court order or settlement identifies the payment as restitution/remediation or to come into compliance with law (identification requirement) and (2) the taxpayer establishes that the payment is restitution/remediation or to come into compliance with law (establishment requirement). Under the regulations, a taxpayer satisfies the identification requirement if an order or agreement specifically states that the payment constitutes restitution or remediation or is for coming into compliance with law or uses a form of those words. A taxpayer may satisfy the establishment requirement by providing documentary evidence of certain elements.
The TCJA also added Sec. 162(q), which disallows deductions under Chapter 1 for a settlement or payment for sexual harassment or abuse and related attorneys' fees that is subject to a nondisclosure agreement. An IRS FAQ clarifies that the attorneys' fees disallowance does not apply to the victim's attorneys' fees (see irs.gov/newsroom/section-162q-faq).
Other deduction disallowances include Sec. 162(c), which applies to illegal bribes and kickbacks, and Sec. 162(g), relating to treble damages for antitrust violations.
The receipt or payment of amounts as a result of a settlement or judgment has tax consequences. The taxability, deductibility, and character of the payments generally depend on the origin of the claim and the identity of the responsible or harmed party, as reflected in the litigation documents. Certain deduction disallowances may apply. Taxpayers that fail to take these rules into account when negotiating a settlement agreement or reviewing a proposed court order or judgment may experience adverse and possibly avoidable tax consequences.
Christine M. Turgeon, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in New York City.
For additional information about these items, contact Ms. Turgeon at 973-202-6615 or firstname.lastname@example.org.
Contributors are members of or associated with PricewaterhouseCoopers LLP.