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Taxation of settlements in employment discrimination cases.

Tax consequences of a cash settlement or judgment award frequency are considered only near the conclusion of the case. This is often when it is too late to alter them. Since the Revenue Act of 1993 has raised the stakes by raising the top marginal rate of income tax, this issue deserves more careful attention.

A plaintiff who has agreed to settle a case for a cash payment of $500,000 (after payment of attorney fees and costs) generally expects to receive that amount. He or she is unlikely to welcome the news that after state and federal income tax the actual recovery will be closer to $300,000.

In some cases, last-minute consideration of the tax liability associated with the settlement may be enough to derail the settlement altogether or force the defendant to increase its offer. Conversely, attorneys can add real value to a case for clients by drafting the complaint and settlement agreement to minimize or avoid subjecting the recovery to income tax.

Although it is not always possible to guarantee the tax results of a settlement or judgment, careful planning and drafting from the start will provide the client the best opportunity for excluding all or part of the amount received from taxable income. Important developments have occurred recently in both case law and the litigating position of the Internal Revenue Service (IRS) in this area. These have provided new opportunities for attorneys practicing employment discrimination law.

The basic rule of income taxation is that all income is potentially subject to tax. However, the Internal Revenue Code (IRC) contains an exception in [sections]104(a)(2). This section allows a taxpayer to exclude from gross income any amounts received as damages "on account of personal injuries or sickness." The exclusion applies whether the damages are the result of a judgment or a settlement, and whether the damages are paid in a lump sum or as periodic payments.

The IRC contains no definition of "personal injuries." The accompanying regulations provide that the damages excluded under [sections]104 are those received as a result of a suit based on "tort or tort-type rights," but does not explain what these rights are.(1)

The courts have made it clear that an injury need not be physical to qualify under [sections]104. However, since a 1989 amendment, punitive damages are taxable if the case does not involve physical personal injuries - and may be taxable even if the case does involve physical injury, as discussed below.

Excludability in Burke

To apply the statutory rule to employment discrimination claims, it is necessary to understand United States v. Burke.(2) In this 1992 case, the Supreme Court discussed how to distinguish between excludable and non-excludable damages in employment discrimination cases.

The plaintiffs brought suit under Title VII for gender discrimination, seeking injunctive relief and back pay. The parties settled, and the defendant paid a lump sum that was distributed among the plaintiffs in amounts based on length of service and rate of pay.

The IRS contended that the payments could not be excluded from gross income as damages for personal injuries. The Supreme Court agreed, based on Title VII as it existed at the time of the settlement.

The outcome of the case no longer provides meaningful guidance because the decision rested on provisions of Title VII that have since been amended. However, the Court's discussion of how to distinguish between excludable damages for tortlike personal injuries and non-excludable damages is the current standard for this determination.

The Court established two important principles in Burke. The first is that in applying [sections]104, a court must look to the nature of the claim underlying the damage award or settlement. Thus, the basic inquiry of the court does not address characterizing or measuring the damages. This principle is important because it allows damages characterized as back pay to be excluded from income in some circumstances.

The second principle is that the way to determine whether a claim is a tort claim is to look to the remedies available for the specific cause of action. The Court noted that in a tort case typically a wide variety of remedies is available to the plaintiff. Title VII as it existed then did not permit a plaintiff to recover damages for pain and suffering, emotional distress, harm to reputation, or other consequential damages. Title VII did not permit recovery of punitive damages or provide a jury trial, as do other federal civil rights statutes. It permitted only equitable relief and recovery of back pay. On this basis, the Court decided that the cause of action was not a tort claim.

Although Burke established the standard for determining whether damages qualify for exclusion under [sections]104, many questions remained as to how the standard should be applied in particular circumstances, including cases under Title VII as amended. In December 1993, the IRS issued Revenue Ruling 93-88, which dispelled the uncertainty for some federal statutory causes of action.(3)

The ruling applied the reasoning of Burke to claims for racial discrimination under Title VII and [sections]1981; to claims for gender discrimination under Title VII; and, to a lesser extent, to claims under the Americans with Disabilities Act (ADA).(4) The IRS indicated that as a result of Burke it had changed its litigating position md would no longer challenge the exclusion of damages paid under some of these provisions.

The ruling makes it clear that damages for racial discrimination in employment received under a [sections]1981 or Title VII claim may be excluded from income under [sections]104. These causes of action permit recovery of a full range of compensatory damages, plus punitive damages. (No mention was made of the availability of a jury trial.)

The IRS concluded that these actions are essentially torts under Burke, and, therefore, compensatory damages, including back pay awarded under these provisions, may be excluded from income. This is true even if the only damages received are back pay.

Types of Discrimination

However, the ruling indicates that in a Title VII case for gender discrimination a further distinction must be made. Title VII defines two types of unlawful employment discrimination. The statute prohibits discrimination with respect to compensation, terms, conditions, or privileges of employment, or "disparate treatment" discrimination. The statute also prohibits classifying employees in a way that adversely affects their employment status if the classification tends to discriminate and is not necessary for business purposes. This second type of discrimination is referred to as "disparate impact" discrimination.

The IRS considers gender discrimination suits for disparate treatment under Title VII to be torts. Thus, consequential damages may be excluded even if the damages are limited to back pay. However, a gender discrimination suit for disparate impact permits recovery of back pay only. A plaintiff may not recover other types of compensatory damages or punitive damages. As a result, the IRS takes the position that back pay recovered in a disparate treatment suit can be fully excluded, but back pay awarded in a disparate impact suit is fully taxable.

In Revenue Ruling 93-88, the IRS said similar principles apply to suits under the ADA. Presumably this means that the IRS will treat awards for disparate treatment as excludable under [sections]104, even if the award consists entirely of back pay. However, an award for disparate impact will be taxable.

The IRS's conclusion that disparate impact claims are to be treated differently from disparate treatment claims has not yet been tested in court. However, taxpayers should no longer have to litigate the issue of the excludability of damages in a racial discrimination case, a disparate treatment gender discrimination case, or a case under the ADA.

The ruling did not address the excludability of damages in suits under the Age Discrimination in Employment Act (ADEA),(5) which permits recovery of both back pay and liquidated damages and provides for a jury trial. The drafter of the ruling has indicated informally that the IRS's position is that claims under the ADEA are not tort-type claims and that damages under the act will be taxable. The government has been litigating this issue vigorously.

Split in the Circuits

The circuits now have split, with the Fifth Circuit and Ninth Circuit holding ADEA damages to be excludable and the Seventh Circuit holding them taxable.(6) Both the Seventh and the Ninth Circuits focused their analysis on the function of the liquidated damages available under the ADEA in deciding whether the statute provides a tort-type cause of action. The Ninth Circuit in Schmitz v. Commissioner followed the Tax Court and the Federal Court of Claims in holding that the ADEA provides a tort-type claim.

The Schmitz court applied a two-part inquiry. First, it determined that although it agreed with the government that one purpose of ADEA liquidated damages is to deter further violations of the statute, the damages are not purely punitive in nature. It concluded that the liquidated damages are both compensatory and punitive and that the cause of action is tort-like under Burke.

Second, the court addressed the government's argument that the liquidated damages were received on account of the defendant's willful behavior, not on account of the plaintiff's personal injury. The court ultimately rejected this argument, concluding that the damages were excludable.

The Seventh Circuit in Downey v. Commissioner also examined the nature of the liquidated damages under the ADEA. This court did not follow recent district court cases that emphasized the punitive nature of the liquidated damages. Instead, the court concluded (with minimal explanation) that the liquidated damages are not compensatory, but rather function as prejudgment interest, and so constitute a contract remedy. Consequently, the court held that both back pay and liquidated damages awarded under the ADEA are taxable.

In November the Supreme Court granted certiorari in the Fifth Circuit case, Commissioner v. Schleier, and will resolve the issue of taxability, at least under this statute. The Equal Pay Act presents similar issues, and the Supreme Court's decision may affect the Tax Court's current position that liquidated damages under the Equal Pay Act are excludable.(7)

The taxability of damages awarded in employment discrimination suits brought under state statutes will be determined under the same principles applied to suits under federal statutes. If a plaintiff is entitled to a jury trial, and if the plaintiff can recover punitive damages as well as compensatory damages such as emotional distress, pain and suffering, or injury to reputation, the cause of action is a tort-type claim. However, if only liquidated damages are available in addition to back pay, then the IRS is likely to take the position that the recovery is not excludable under [sections]104.

Claims for Defamation

Suits for employment discrimination may include associated claims for defamation. The IRS has ruled that for tax purposes a distinction must be made between awards for injury to personal reputation and damages to professional or business reputation.(8) The ruling treats damages for injuries to professional or business reputation as taxable, and damages for injury to personal reputation as excludable, based on the Tax Court position at the time the ruling was issued. The Tax Court has since reversed its position by holding that all damages for injury to reputation are excludable.(9) The IRS has not withdrawn the ruling but is reconsidering it.

An employment discrimination award or settlement may also include attorney fees and expenses. If all or part of the award or settlement is excludable under [sections]104, a corresponding part of the fees and expenses recovered is also excludable.(10) However, if a plaintiff recovers an excludable award and pays attorney fees from his or her own finds, the fees cannot be deducted because expenses incurred to generate tax-free income are not deductible.

Interest on a settlement award or judgment is always fully taxable, even if the underlying award is excludable as personal injury damages under [sections]104. The Tax Court recently held that interest is taxable even when it is prejudgment interest required under state statute.(11) However, a district court in Colorado has disagreed, concluding that prejudgment interest mandated by statute is an element of compensation, damages and so is not taxable.(12) When the interest is taxable, the part of the attorney fees attributable to the interest is deductible.

Controversy also surrounds the tax treatment of punitive damages in cases involving physical injuries. The 1990 amendment to [sections]104 is phrased in the negative, so that while it is clear that these damages are taxable when physical injuries are not present, it is not clear that these damages are excludable if physical injuries are present. In a footnote to Burke, the Supreme Court seems to have assumed that punitive damages are excludable if physical injuries are present.(13)

However, recently both the Ninth Circuit and the Court of Appeals for the Federal Circuit have held that punitive damages are awarded on account of a defendant's malfeasance and not on account of a plaintiff's personal injuries. These courts concluded that punitive damages are not excludable under [sections]104.(14)

The Sixth Circuit held to the contrary in August, increasing the uncertainty on this issue.(15) Although all these cases were decided under [sections]104 before amendment, the logic the courts used could apply equally to the amended statute.

The language of [sections]104(a)(2) and the accompanying regulations make it clear that it is not necessary for a case to proceed to judgment in order to exclude a recovery. Amounts received in lieu of prosecuting a suit are excludable.

Several groups of former IBM employees plan to test how far this language can be stretched. On leaving IBM, these employees signed general releases that included any possible employment discrimination claims. The company gave them a severance package and withheld federal income tax. Some of the employees have filed suit for refunds on the theory that the severance pay actually represents settlement of age discrimination claims that is excludable under [sections]104(a)(2). Case law is not favorable to the employees' position,(16) but the issue is one that bears watching.

In addition to the legal issues outlined above, there are practical issues in determining what parts of a settlement or award may be excluded from income. Most plaintiffs file a complaint that includes several different causes of action. Often a complaint will include a contract claim and a request for punitive damages as well as claims for employment discrimination that are clearly personal injury claims.

When the plaintiff receives a payment as part of a settlement or judgment award, there remains the practical issue of determining which parts are excludable as damages for the personal injury claims and which are taxable as damages for contract claims or punitive damages. Here, careful planning and drafting can have an impact on the tax consequences of the award or settlement.

The most important factor in dividing a damages payment into taxable and excludable parts is the language of the judgment or settlement agreement. If no allocation between taxable damages and excludable damages is made, the IRS will likely allocate all or most of the payments to taxable damages. The taxpayer will have the burden of showing that the IRS is wrong.

If the settlement agreement or judgment does contain an allocation, the parties' allocation will be given significant weight. In March 1994, in McKay v. Commissioner, the Tax Court reiterated its position that the language of the agreement is the most important factor in determining whether a payment is excludable as damages for a personal injury.(17) However, the language may not always be enough to ensure that the parties' allocation is respected.

In McKay, the Tax Court indicated it upheld the allocation of damages in the settlement agreement largely because the parties had engaged in arms-length negotiations as to the allocation. The plaintiff brought suit under many different theories and at trial was awarded multiple damages for a Racketeer Influenced and Corrupt Organizations Act (RICO) claim as well as punitive damages.

After trial, the parties negotiated a settlement for a lower figure. The defendant refused to allocate any of the payment to punitive damages or the RICO claim. The court indicated that the adversarial positions of the parties while negotiating showed that the agreement reached accurately reflected the underlying claims settled.

The previous month, the Tax Court decided Robinson v. Commissioner.(18) This case illustrates the circumstances in which an allocation by the parties may not be respected. The parties reached a settlement after a jury trial. The defendant agreed to pay the plaintiff a lump sum and allowed the plaintiff to allocate the payment as he wished, since the allocation did not affect the defendant. The plaintiff allocated 95 percent of the payment to an excludable tort claim and 5 percent to a taxable contract claim.

The Tax Court refused to respect the allocation even though it was entered as a final judgment by the state court, because the agreement was uncontested, nonadversarial, and entirely tax-motivated. In making a new allocation, the court looked to the jury award and then adjusted it because the court believed that both parties expected the jury's award of punitive damages to be reduced. The amount awarded as contract damages equaled 62 percent of the final settlement amount. Therefore, the court determined that 62 percent of the settlement constituted taxable contract damages.

Drafting the Complaint

Claims in the complaint are also important in determining the allocation of payments to taxable and nontaxable damages. An allocation in a settlement to a claim that was not pleaded in the complaint or was added later as an afterthought is unlikely to be respected.

The IRS has ruled that at least in some circumstances, it will look first to the complaint and will allocate a settlement award in the same proportions as the damages are claimed in the complaint.(19) Thus, if in a complaint a plaintiff claimed actual damages for libel of $10,000 and punitive damages of $1 million, the IRS might treat about 1 percent of any settlement payments as excludable.

The IRS or a court may also consider the evidence introduced at a trial in allocating damages. If a personal injury claim was pleaded in the complaint but no evidence was introduced at trial to support the claim, an allocation of part of a settlement or judgment award to that claim is less likely to be respected.

A plaintiff's attorney preparing an employment discrimination suit will want to be sensitive to these tax issues from the start of the case. In deciding which claims to include in the complaint, the attorney should keep in mind which theories will result in taxable recoveries.

Although a taxable recovery obviously is preferable to no recovery, the attorney should consider tax consequences. The attorney should consider the possible consequences of assigning dollar values to different claims - in particular, the possible effect of assigning a disproportionately large value to a claim for punitive damages, which are taxable if no physical injury is present (and possibly even if an injury is present).

At trial, the attorney should keep in mind tax consequences when deciding what evidence to introduce, with an eye to ensuring that claims for excludable damages are supported. When drafting a settlement agreement or release of claims, the attorney should be sure to allocate payments between taxable and nontaxable damages. If the allocation is the subject of negotiations between the parties, the attorney may wish to document the negotiations.

An allocation in the agreement will be particularly important if no complaint has been filed and the agreement is simply a release of claims. Then, the release will be the only evidence showing what claims the payments reflect.

If the release makes no allocation of the payment, the IRS will be free to make its own allocation. If the case is to be resolved through arbitration or mediation, the attorney should ensure that the arbitrator or mediator is aware of the tax issues involved to avoid an unallocated lump sum award.

The defendant in these cases faces fewer tax issues. The defendant generally can deduct payments made under a settlement or judgment whether or not they are taxable to the plaintiff. However, some reporting issues will arise.

If the damages include back pay, the defendant will have to decide whether the plaintiff can exclude the back pay as personal injury damages. If the back pay is not excludable, the defendant is responsible for withholding income tax.

The defendant may be inclined to withhold - even if the plaintiff intends to treat the recovery as excludable personal injury damages - to eliminate the risk that the IRS will determine the recovery is taxable back pay and try to recover the withholding amount from the defendant. However, plaintiffs are likely to resist this approach for two reasons.

First, they typically will expect to receive the agreed-on amounts in a single payment and will be unhappy if they can recover the full amount only by filing for a tax refund. Second, the IRS is less likely to accept a plaintiffs position that the recovery is an excludable recovery of personal injury damages if the defendant has treated it differently for tax purposes. The defendant may consider a tax indemnity from the plaintiff, especially because failure to withhold can result in personal liability for the officers or employees responsible for withholding.

If there has been no withholding, the plaintiff also will face the issue of reporting the recovery. The plaintiff who simply treats the recovery as excludable and does not report it runs the risk of being assessed penalties as well as interest if the IRS determines that the recovery was taxable. The plaintiff who reports the recovery can be sure that no penalties will be assessed, but the tax return probably will receive much closer scrutiny.

One commentator, in discussing the recent refusal of the Tax Court to uphold penalties assessed when a taxpayer excluded a recovery that was later determined to be taxable, concluded that the case indicated that taxpayers can now exclude recoveries from income without fear of penalties.(20) However, neither the Tax Court nor the IRS has given this assurance, and penalties remain a real risk for a taxpayer.

Structured Settlements

Finally, if the settlement or award will be excludable, the parties may wish to consider a structured settlement that provides for periodic payments. In general, a structured settlement is funded through an annuity.

In some circumstances, such as a case involving physical injury or sickness, the parties may arrange for the annuity to be held by a third party, usually a structured settlement company. In such a case, the parties typically enter into a settlement agreement providing for fixed and determinable periodic payments. The agreement permits the defendant to assign its obligation to make the future payment to the structured settlement company. The agreement also provides that the assignment releases the defendant from the obligation to make the future payments.

The structured settlement company uses the cash received from the defendant to purchase and hold the annuity that provides the periodic payments to the plaintiff. If the arrangement complies with the applicable tax rules, the defendant can claim a deduction at the time it makes the payment to the structured settlement company.

The plaintiff will receive all of the payments tax-free. Part of each payment is actually interest, but the interest income is reported by the annuity owner, not the plaintiff. Depending on the financial position and investment skills of the plaintiff, this may produce a greater economic benefit than receiving a lump sum and investing it. Where the plaintiff has taken another job, or will in the future, and thus continues to pay income tax, the tax savings will usually be substantial.

If a structured settlement is used, the defendant must ensure that the appropriate tax rules are followed. If the rules are violated, the defendant will be able to take deductions only as the plaintiff receives payments, even though the defendant has paid the entire annuity up front.(21) If a deduction is not an important factor (because, for example, the defendant is a government entity), the parties will have much more flexibility in arranging a structured settlement.

The plaintiff's attorney will want to think carefully about negotiation strategy when a structured settlement is used. Different payment schedules may have quite different costs to the defendant, and an expert should be consulted to determine the cost (present value) of the structured settlement.

The plaintiffs attorney can negotiate based on the amount to be paid by the defendant without adverse tax consequences. However, the plaintiff should take care not to enter an enforceable agreement that fails to provide for periodic payments if all or part of the recovery may be taxable. If there is an enforceable agreement that refers only to a lump sum, the IRS may treat the plaintiff as having received the entire lump sum in the year of settlement under the doctrine of "constructive receipt."(22) To avoid this possibility, the plaintiff should release his or her claims only in a signed document that includes exact terms for any periodic payments.


(1) Treas. Reg. [sections]1.104-1(c). (2) 112 S. Ct. 1867 (1992). (3) Rev. Rul. 93-88, 1993-2 C.B. 61. (4) 42 U.S.C. [subsections]12101-12213. (5) 29 U.S.C. [subsections]621-34. (6) See Schleier v. Commissioner, 26 F.3d 1119 (5th Cir.) (unpublished opinion affirming an order of the Tax Court), cert. granted, 115 S. Ct. 507 (1994); Schmitz v. Commissioner, 34 F.3d 790 (9th Cir.), petition for cert. filed, 63 U.S.L.W. 3462 (U.S. Nov. 23, 1994) (No. 94-944). Contra Downey v. Commissioner, 33 F.3d 836 (7th Cir.), reh'g en banc denied, 199 U.S. App. LEXIS 33068 (7th Cir. Nov. 18, 1994), petition for cert. filed, 63 U.S.L.W. 3476 (U.S. Dec. 5, 1994) (No. 94-999). (7) Bennett v. Commissioner, 67 Tax Ct. Mem. Dec. (CCH) 2817 (1994). (8) Rev. Rul. 85-143, 1985-2 C.B. 55. (9) Threlkeld v. Commissioner, 87 T.C. 1294 (1986), aff'd, 848 F.2d 81 (6th Cir. 1988). (10) Fite v. Commissioner, 66 T.C.M. (CCH) 1588 1993). (11) Kovacs v. Commissioner, 100 T.C. 124 (1993), aff'd per curiam, 25 F.3d 1048 (6th Cir.), cert. denied, 115 S. Ct. 424 (1994). (12) Brabson v. United States, 859 F. Supp. 1360 (D. Colo. 1994). (13) "Congress amended section 104(a) to allow the exclusion of punitive damages only in cases involving `physical injury or physical sickness.'" Burke, 112 S. Ct. 1867, 1871 n.6. (14) Hawkins v. United States, 30 F.3d 1077, 1080 (9th Cir.), petition for cert. filed, 63 U.S.L.W. 3487 (U.S. Dec. 9, 1994) (No. 94-1041); Reese v. United States, 24 F.3d 228 (Fed. Cir. 1994). (15) Horton v. Commissioner, 33 F.3d 625 (6th Cir. 1994). (16) See Taggi v. United States, 35 F.3d 93 (2d Cir. 1994); Lee A. Sheppard, The Tax Treatment of IBM's Golden Handshakes, 65 TAX NOTES 946 (1994). (17) 102 T.C. 465 (1994). (18) 102 T.C. 116 (1994). (19) Rev. Rul. 85-98, 1985-2 C.B. 51. (20) William L. Raby, Why Should Anyone Pay Taxes on Litigation Settlements? Raby Asks, 63 TAX NOTES 213 (1994). (21) I.R.C. [subsections]461(h), 130 (1988); Treas. Reg. [subsections]1.461-4(g)(1)(ii)(B), 1.461-6. (22) Treas. Reg. [sections]1.451-2(a).
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Title Annotation:Employment Law
Author:Tenney, Cornelia R.
Date:Mar 1, 1995
Previous Article:The after-acquired evidence doctrine: an insidious defense.
Next Article:Protecting railroad workers with the ADA.

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