How Does the New Tax Law Affect Litigation Settlements? Ask Tax Expert Rob Wood
Plaintiffs and defendants (and their lawyers) are all affected by the Internal Revenue Code and how the IRS interprets it. Effective January 1, 2018, some changes to the tax code have changed the way settlements are taxed. Of course, not everything has changed. Tax lawyer Rob Wood discusses the taxation of settlements in this report. He also wrote about it in a Tax Note article, “Settlement Awards Post-TCJA.”
At the outset, Wood points out that the subject of taxation of settlement awards is a large one. Whenever disputes are being settled and money is involved, tax rules will be an important issue for all concerned. Ideally, a settlement award will be taxed fairly, and the defendant hopes the payment is deductible. Most of the rules, Wood says, have not changed because of the Tax Cut and Jobs Act.
Wood notes that there have been a couple of changes worth noting under the new tax law. One change relates to attorneys’ fees from the perspective of the client. In other words, is the fee deductible? The other big change relates to settlements in sexual harassment cases, a subject Wood has reported on previously.
Wood explains that, historically, defendants in sexual harassment cases were able in most instances to deduct the amount of payments to settle sexual harassment cases. The attorneys’ fees paid by defendants were also deductible. The new tax law says that these payments are no longer deductible in a sexual harassment case if the settlement agreement includes a confidentiality provision. “That’s a pretty big change in the law.”
Wood says that while this new law seems clear, it is not so clear when there is an employment law case involving a number of claims, one of which is sexual harassment. Suppose there are four separate claims. Can the settlement be divided up so that the portions not related to sexual harassment are deductible? Wood believes that no one really knows the answer to that question as yet.
The treatment of attorneys’ fees is an important change in the new law. The change occurs because miscellaneous itemized deductions are eliminated under the new tax law. If a taxpayer does not qualify for an “above-the-line” legal fee deduction, the legal fee might not be deductible. There may be some options available to a plaintiff, but this is an area where expert tax advice is very important for someone seeking to avoid paying tax on the attorney’s fee portion of a settlement amount.
As for the things that have not changed under the new tax law, Wood notes that settlements of judgments are taxed the same as before. Some are tax free, others are treated as income. The basic rule for plaintiffs, Wood says, is that “everything is income unless you can prove it isn’t.” The exception is for true physical injury cases. In such a case, the contingent fee payment is not a concern because the award is not taxable.
Wood suggests that a plaintiff who is settling an action for damages should get tax advice in every instance before signing a settlement agreement.
Robert W. Wood is the Managing Partner of Wood LLP, San Francisco. Often listed among the best tax lawyers in America, Wood has broad experience in corporate, partnership and individual tax matters. Concerning the tax treatment of litigation settlements and judgments, he is perhaps the preeminent tax lawyer in the United States. He is also an authority on merger and acquisition tax matters, tax opinions, offshore account and entity disclosures, and many types of tax controversies. The Legal Broadcast Network is a featured network of Sequence Media Group.