Changing settlement language sometimes doubles what a plaintiff keeps—without any cost to defendants. Depending on the case, language can reduce taxable income, increase deductions, defer tax liability, and even secure a tax subsidy. But tax strategies can fail when defendants object. In our experience, defendants withdraw their objections when answered with information and confidence. Otherwise, objections win the day at the plaintiff’s expense.
Defendants and casualty carriers often are overly conservative—if you’re not pushing them to the middle, they may not get there. And if taxes and tax reporting don’t come up, you’re probably leaving money on the table. Though not the subject of this article, it’s worth noting that plaintiff counsel is duty-bound to flag the importance of this issue for clients.
This article explores the importance of plaintiff tax strategies, defendants’ role in effecting those strategies, why defendants object, and how to overcome their objections.
I. Keeping More of the Recovery
You can spend months negotiating to increase a recovery by 5%. You can lose a settlement because the final offers are 10% apart. But sometimes, by considering taxes, plaintiffs keep more while defendants pay less. This isn’t magic or tax scheming; it’s a government benefit that’s often ignored. There are many opportunities to reduce taxes. Here are three examples.
Physical Injury—Maximizing Medical Deductions
In general, lawsuit proceeds paid on account of personal physical injuries are received tax-free; see Internal Revenue Code §104(a)(2). Thus, a plaintiff is unlikely to owe tax unless her settlement compensates for punitive damages, interest, or abiding by a nondisclosure agreement.
But allocating a reasonable portion of settlement proceeds to future medical expenses may save the plaintiff significant future taxes. Without doing so, she may be unable to deduct medical expenses related to her case until she has spent her entire recovery on medical expenses, as noted in IRS Rev. Rul. 75-232. In a paraplegic case, for example, this could increase the plaintiff’s taxes by millions of dollars.
Notably, this strategy requires that the defense agree to settlement language identifying a particular portion of settlement proceeds as compensation for medicals.
Claims Affecting Family Members—Reduce Income and Estate Taxes
Claims of all sorts affect a plaintiff’s family; this offers tax planning opportunities. When a former plaintiff receives nursing care from a family member and pays for it, those payments are taxed as compensation for services. However, if that family member receives settlement proceeds as a co-claimant, she can avoid substantial taxation.
When a former plaintiff dies, her estate pays tax on her remaining settlement cash or structured settlement payments to the extent the value exceeds the estate tax threshold—i.e., $12 million in 2022. It may also pay a generation-skipping tax. But those amounts avoid estate taxation if, instead, her beneficiaries receive such amounts as co-claimants in the settlement.
Whether family members and other beneficiaries can receive settlement proceeds as co-claimants is highly fact-specific. In some states, statutes and common law may obstruct their claims for emotional distress, loss of consortium, or loss of society. But if a claim could conceivably succeed, the defense is justified in paying to extinguish it. By considering possible co-claimants, settling parties can sometimes reduce both income and estate tax. Here again, the strategy requires the defense to participate—in this case, by treating and paying the family member as a co-claimant.
Creating Lifetime Income—Claiming a Tax Subsidy
Since the 1980s, plaintiffs have used structured settlements like a 401(k) plan. The arrangement has evolved over time but has always offered a tax deferral opportunity for taxable and tax-free settlements. Like the pre-retirement incentive of a 401(k), the tax benefits of a structured settlement are offered to encourage plaintiffs to fund their financial futures and avoid dissipating a lump sum recovery.
Using a structured settlement for tax-free damages allows a plaintiff to indirectly invest the settlement value entirely tax-free. In a taxable damages case, it allows the plaintiff to defer taxation on the settlement and indirect investments. Today, plaintiffs can choose from any number of investment options, including various types of annuities and growth funds.
This strategy doesn’t require the defendant to assume liability, but their consent is needed. The arrangement requires additional language in the settlement agreement and an additional document by which a structured settlement provider assumes all obligations of the defendant to make future payments.
II. How Defendants Affect Plaintiff Taxation
Effecting these tax-saving strategies typically involves at least some defense participation. This is because in at least four distinct ways, a plaintiff’s tax treatment and tax risk are heavily influenced by defendants’ actions.
First, the IRS and courts have regularly said that a plaintiff’s taxation “hinges on the payor’s dominant reason for making the payment”; see Green v. Commissioner and IRS TAM 200722013. To determine the “dominant reason,” courts “first look to the language of the [settlement] agreement.” Thus, a defendant’s intent and consent to language at settlement are critical.
Second, a largely tax-free recovery can become wholly taxable if the defendant will not allocate, i.e., insists on general release language. In Forste v. Commissioner, the U.S. Tax Court wrote, “In those cases where a settlement agreement fails to allocate the proceeds … and the taxpayer otherwise fails to establish the specific portion of the settlement amount [that is received tax-free], the entire amount has been held to be taxable.”
Third, a defendant’s decision to report some of the recovery as taxable to the plaintiff, and how much gets reported, greatly affects the plaintiff. The IRS’ information matching program aims to detect differences in reporting. Thus, a plaintiff cannot report less taxable proceeds than the defendant without significant risk of audit and challenge. As you’d expect, the IRS has used defendants’ reporting as evidence of plaintiff underreporting, as seen, for example, in Connoly v. Comm’r.
Fourth, a defendant’s consent to language at settlement provides significant protection to the plaintiff if the IRS chooses to audit and challenge the plaintiff’s tax reporting of the settlement proceeds. In general, a taxpayer bears the burden of proof upon an IRS challenge. However, with a showing of “credible evidence,” that burden shifts to the IRS. In general, express language in a settlement agreement constitutes sufficient credible evidence, as noted in Forste. Again, the plaintiff’s need for the defendant’s consent is substantial.
Plaintiffs can reduce, but not escape, defendants’ influence on tax treatment through a qualified settlement fund, or QSF. QSFs are typically used in mass torts and multi-claimant cases and allow a defendant to obtain a full release in exchange for a tax-deductible payment. Using a QSF puts the QSF administrator, rather than the defendant, in charge of deciding to issue plaintiffs IRS Form 1099-MISC. However, plaintiff taxation is still driven by the defense. IRS regulations state that a plaintiff’s tax treatment of amounts received from a QSF is determined “as if the [payment] were made directly by the [defendant].” And as discussed above, such treatment hinges on the defendant’s intent, best evidenced in a settlement agreement signed by the defendant.
Even if a QSF is used, plaintiffs seeking to minimize taxes are affected by defendants’ decisions.
III. Responding to Defense Concerns
Defendants often cite three liability concerns in objecting to settlement language or structures proposed by plaintiffs: defendant’s liability to the plaintiff in giving tax advice, defendant’s liability for IRS penalties, and defendant’s liability for under-withholding. Only the third of these materially exposes the defendant, and only in employment cases when the parties don’t properly allocate.
The first concern is the easiest to resolve. By stating clearly that the plaintiff has not received and will not rely on the defendant for tax advice, the defendant can avoid exposure. Stronger language is always an option and doesn’t add risk to the plaintiff.
The second concern is more technical. The defendant is required to report the taxable portion of the recovery on IRS Form 1099-MISC. Failure to do so exposes the defendant to a $250 penalty. A greater penalty applies if the failure was “knowing or willful.” In that case, the penalty is 10% of the reportable amount.
We have never heard of the IRS asserting either penalty against a defendant in a non-wage case. This is likely because the amount reportable by the defendant is largely dictated by the defendant’s own reason for making the payment—see the discussion above. Defendants also are relieved of the obligation to issue 1099-MISC forms when they don’t have enough information to determine the taxable portion. For example, a defendant probably cannot identify the taxable portion of reimbursements it pays to the plaintiff for medical expenses—to know that, the defendant must know which of those expenses the plaintiff previously deducted. In most cases, the most convincing argument to the defense is a technical explanation of the reasonableness of the plaintiff’s proposed tax treatment.
The third concern risks real exposure. However, if handled correctly, there is still considerable safety. The defendant will owe the defendant’s and the plaintiff’s share of employment taxes if the IRS proves that the defendant failed to withhold on the appropriate amount of wages at settlement; see IRC § 3102(b) and § 3403. Additional penalties and interest may be imposed, especially upon a finding negligence or fraud; see IRC § 6601, § 6662, and § 6663. For this reason, defendants should carefully consider the proper portion of a recovery to treat as wages. Fortunately, there are many cases considering the proper allocation of wages and non-wages at settlement. Thus, reducing employment tax through the allocation of wages can often be used without risking defendant exposure.
IV. Recognizing and Responding to Defense Obstruction
Defendants sometimes substantially undermine the plaintiff’s desired tax position by demanding or rejecting language in the settlement agreement. Such actions often provide the defendant little or no protection. In our experience, you can quickly overcome these positions with information and confidence.
Defendants sometimes insist on “general release” language in the settlement agreement. Since the tax treatment of each dollar hinges on the defendant’s reason for paying that dollar, refusing to allocate proceeds among claims and damages can make taxable an otherwise partially tax-free settlement, as noted in Forste. Response: Clarify the need for allocations and consider offering to agree to a general release in exchange for a larger payout—the defense won’t accept, but they’ll start associating the issue with value. Propose defense-friendly allocation language, making sure to reference proceeds as compensating for particular alleged harms. Importantly, remove references to taxation.
Defendants sometimes insist on “disavowing” language in the settlement agreement that states why proceeds are being paid. Since tax treatment of proceeds hinges on the defendant’s reason for making payment, disavowals undermine the value of any settlement language and allocations, as seen in Metzger v. Commissioner. Response: Clarify that defendants need not make a tax representation but that it’s critical that defendants state their intention in making payment. This shouldn’t pose a risk to the defense. Sometimes, you can even excerpt language from a defense briefing, letter, or email that provides the information needed.
Defendants sometimes insist on “tax indemnification” language in the settlement agreement, binding the plaintiff to financially insure the defendant from liability, penalties, and legal costs. Unfortunately, the IRS and courts have used such indemnifications as evidence that the defendant didn’t truly believe the language in the settlement agreement. See, for example, Vincent v. Commissioner. In most cases, there is no risk to the defendant in agreeing to reasonable language that helps the plaintiff. In those cases, demanding a tax indemnification erodes the purpose of such language. Response: Clarify how that language puts plaintiff at risk, offer to include it for an increased payout, and inquire what particular liability the defense has in mind so that you can respond to the concern.
In responding to any defense “obstruction,” we’ve regularly found it effective to “offer to comply” in exchange for a larger payout or to patiently ask for the basis for the defendant’s position. Above all, answer immediately that the issue is important—even if you later decide to relent, you may be able to extract value in doing so.
Tax is technical, and many avoid thinking about it even when significant savings are available. But in negotiating a settlement, considering tax can increase settlement value enough to close the gap between competing offers. And even where there is no gap, it can dramatically increase what your client keeps without costing anything of the defense.
Unfortunately, because defendants and casualty carriers often lack this knowledge and often stick to a conservative “do it like we always do it” position, they stand between your client and available tax savings. In our experience, these disputes are almost always resolvable. Our best advice: If you don’t have a financial or tax adviser on call who knows these issues, resolve that problem first.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Jeremy Babener is a tax lawyer focused on settlement strategies. He is special tax counsel at Lane Powell PC in Portland, Ore., and has served in the U.S. Treasury’s Office of Tax Policy.
Don Engels consults on settlement strategies, often using tax savings to benefit both sides. He consults for Ringler Associates, Inc., and the Settlement Tax Group in Chicago.
Deborah Hresko, CPA, advises plaintiffs and counsel on a range of tax and accounting issues. She began her career at KPMG and now serves at C&L Value Advisors in Tampa, Fla.
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