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Unforeseen Consequences: Tax Treatment of Litigation Proceeds and Expenses

Posted by Sweeney Conrad, PS on Jun 10, 2021 11:57:38 PM

LitigationWhen a company is involved in litigation—as either a plaintiff or a defendant—it is essential that the management team and legal counsel consider the potential tax implications of the action as early as possible. Advance planning and consultation can have a major impact on both the tax treatment of any proceeds and the deductibility of attorneys’ fees and other expenses.

Taxation of Settlements and Payments

A fundamental principle of U.S. tax law is that all income is taxable, regardless of its source, unless it is specifically exempt by a section of the Internal Revenue Code (IRC). For individual taxpayers, one such exemption is found in IRC Section 104, which says that damages a taxpayer receives on account of personal physical injuries or sickness do not need to be included as part of that taxpayer’s gross income.

Note, however, that this exemption does not apply to punitive damages a court may award. If your company is the defendant in a personal injury case, knowing the potential tax treatment a plaintiff can expect is often helpful when discussing a possible settlement.

Of course, most commercial litigation involves issues other than physical injuries or sickness, and the proceeds from those cases involving business entities are usually taxable. In such cases, the critical issue is whether those proceeds are taxed as ordinary income or as a capital gain—a distinction that will have a major financial impact for a successful plaintiff.

The central question taxing authorities and courts consider when determining the tax treatment of a settlement or award is, “In lieu of what were the damages awarded?” In other words, what type of loss is the payment intended to replace?

Consider, for example, a breach of contract or intellectual property dispute. If the proceeds of such an action are intended to reimburse the plaintiff for lost profits, the award would be taxed as ordinary income. On the other hand, if the payment is actually meant to reimburse the company for damages to a capital asset, such as loss of goodwill or diminished value of its capital investment, the proceeds could be treated as a nontaxable return of capital. Any proceeds that exceed the company’s basis in that asset would be taxed as a capital gain.

Note that it does not matter how the case is settled—that is, whether it is resolved through a court judgment, negotiated settlement, arbitration, or other means. What matters is how the proceeds are characterized. To determine this, taxing agencies will look at the text of the court award or settlement agreement, but the primary evidence they consider is the wording of the original complaint or claim itself. This is why it is so important that management and legal counsel involve their tax team as early as possible whenever they consider legal action.

Deductibility of Expenses

For individual taxpayers, the Tax Cuts and Jobs Act (TCJA) of 2017 eliminated most miscellaneous personal deductions—including the deductions for legal fees—until 2026. The loss of this deduction can create tax issues when legal fees are paid under a contingency arrangement. The taxpayer will be taxed on the full settlement but will not be able to deduct the portion retained by the attorney as a contingent fee. However, the TCJA made an exception to allow deductions for personal legal fees that individuals incur in employment cases involving whistleblowing or claims of unlawful discrimination.

For businesses, on the other hand, attorneys’ fees and legal costs are generally considered an ordinary and necessary business expense, making them deductible. An important exception, which was also part of the TCJA, applies to sexual harassment or sexual abuse settlements that include nondisclosure agreements. Any payments a company makes in such cases, and attorneys’ fees related to such a settlement, are specifically not deductible.

The tax treatment of litigation proceeds and expenses involves many complex questions with detailed tax code provisions and extensive case law that must be considered. To avoid unforeseen consequences, all parties involved should consult with their tax advisors as early as possible in the litigation process.

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