We all know we're supposed to pay taxes on our income. But what exactly is income?
The answer is more complicated than you might think, and, if you're not careful, you might have to pay taxes on something you never expected.
The courts have defined "income" to include all accession to wealth, clearly realized, over which you have dominion. Essentially, that means income is anything of value that you receive to do with as you please, for which you do work or because it is obligated by contract. And, unless it's excluded as income by the Constitution or by statute (like municipal bond interest), it's taxable!
However, one of the most basic tenets of tax practice is that if money received merely returns you to your original starting point, if it just makes you "whole" again, it's not "accession to wealth," and it is not income.
Taxed on the gains
When you sell stock, only the gain, the excess of what's received over your cost basis -- normally, what you paid to buy the stock and sell it -- is taxed as income. Likewise, if you lose an arm and receive an insurance settlement for that loss, the settlement isn't taxed because it only makes you "whole" again (at least in a financial sense).For years, that seemed reasonable -- if anything in our Tax Code can be considered "reasonable" -- until the Small Business Job Protection Act of 1996 changed all the rules.
The big rule change on personal injuries is this: Unless the injury is physical, any settlement or award is taxable. That makes awards for discrimination, emotional distress and/or injury fully taxable -- even though these awards are intended only to make you whole again.
For a verdict or settlement to be tax-free, it must be structured to meet two new code requirements:
- A physical injury or illness must have occurred. Without either, the proceeds will clearly be taxable.
- The injury or illness must be the result of a tort -- a wrongful act, injury or action. If you successfully sue someone who hit your car, the award will be tax-free. But if you win a back-pay judgment from a breach of contract suit, the award is taxable income. It resulted from a contract dispute.
What appears simple and straightforward ain't necessarily so. Here's where creative planning and litigation can save substantial dollars.
Planning a settlement
Let's look at emotional distress. Emotional distress can produce physical symptoms -- headaches, stomach pains, insomnia and the like. As a result, you may believe that any award or settlement for emotional distress might not be taxable. Sorry. Emotional suffering, no matter how bad the headaches, doesn't come free of a tax bill, except to the extent of any amount paid for medical care attributable to the distress.But let's say you're suing for sexual discrimination, and you were subject to unwanted touching and suffered bruises. This changes the situation. With pictures and a doctor's testimony about the injury, significant damages could be allocated to the "physical" injury, and these damages would be beyond the reach of the Internal Revenue Service.
Let's say you negotiate a $1 million settlement on a sexual discrimination suit that involves some physical injuries. In the 35% tax bracket, that leaves you with $650,000 after-tax.
But if you structured the settlement for $250,000 for the discrimination, and $500,000 for the physical bruising, you would net, after tax, $662,500 -- a gain of $12,500 more for you. And thanks to your magnanimity, the defendant would save $250,000.
Paying the lawyers
The taxation of legal awards and settlements becomes even more complicated when you add in the legal fees.Lawyers in personal-injury cases usually work on a contingency basis. So your lawyer gets paid only if you win, and his fee is a percentage of your award or settlement.
The courts used to be mixed on how to handle the fees. Some courts hold that the fees create a right of ownership -- or attorney's lien -- for the lawyers. Since the lawyer owns that portion of the award, it's not your asset and therefore shouldn't considered taxable income.
However, most courts, including the U.S. Tax Court, held contingency fees to be a creditor's right, a right to be paid by you, as the attorney's client. In such cases, the entire award is included in your gross income, and is taxable.
Here's how important this distinction was:
Let's say you receive a taxable award of $1 million and have to give your lawyers 40%, or $400,000.
If your case is in a state where the fees create that lien we talked about, you were facing getting taxed only on $600,000. However, in the second case, you faced tax on the whole $1 million.
But how about a deduction for the $400,000 paid to your attorney?
Yes, you get the deduction, but only as a miscellaneous itemized deduction. So first you have to itemize, which you might not have had to do in the original instance. More importantly, your miscellaneous itemized deductions must be reduced by 2% of your adjusted gross income. So, if you had no additional income (a very conservative assumption), you lose, at a minimum, at least 2% of $1 million, or $20,000 in deductions.
The Supreme Court recently resolved the dispute. The court ruled that the legal fees are allowed only as a miscellaneous itemized deduction.
But Congress modified the rule slightly in the American Jobs Creation Act of 2004. Under this law, legal fees from claims based on unlawful discrimination and certain other federal claims (including, but not limited to, whistle-blower actions), are now above-the-line deductions. You don't even have to itemize to take those!