Navigating the Federal Tax Consequences on Settlements and Judgments

The federal income tax consequences associated with litigation and settlements can be complex. From the plaintiff’s perspective, primary concerns are whether any payments received are taxable and, if so, whether the payments are subject to ordinary income tax rates or reduced capital gains rates. Because attorneys’ fees are routinely a high expenditure in the litigation, plaintiffs routinely request guidance on whether they can deduct their attorneys’ fees.

The origin of the claim doctrine addresses these issues. Although deceptively simple in theory, the analysis required under the doctrine is much more difficult in practice. Under the origin of the claim doctrine, the relevant inquiry is “in lieu of what were payments made?” To ensure consistency in tax treatment, the doctrine seeks to tax the payment based on what it is a substitute for.

The Origin of the Claim Doctrine

The federal income tax consequences of payments arising from judgements or settlements are the same. Because most litigation is settled rather than litigated, I’ll discuss settlement payments below. My two examples below also help illustrate the origin of the claim doctrine as applicable to settlements.

Example One: Tim purchases a painting for $30,000. John negligently destroys the painting, and Tim engages an attorney to recover damages against John. Tim’s attorney sends a demand letter to John, and John and his attorney agree to enter into a settlement agreement in which John will pay Tim $30,000.

Example Two: Laura is a farmer and plants crops one season. Sara owns land adjacent to Laura’s crops. After Laura has planted her crops, Sara negligently causes irrigation water from her land to spill over to Laura’s land destroying Laura’s crops. Laura’s attorney sends a demand letter to Sara, complaining that Laura would have earned $30,000 of net profits from the crops had they been harvested. Laura and Sara enter into a settlement agreement in which Sara agrees to pay Laura $30,000 for her damaged crops.

In example one and two, both Tim and Laura have received $30,000. For tax purposes, that is where the similarity ends. Under the origin of the claim doctrine, federal tax law looks to the nature of the payments received by Tim and Laura to determine whether the payments are taxable or non-taxable. Because Tim has received a payment for a damaged asset that he purchased for $30,000, Tim’s receipt of $30,000 to replace that asset is a non-taxable recovery of capital. By comparison, Laura has received $30,000 for profits that she would have earned but for Sara’s negligence. If Sara had not acted negligently, Laura would have earned $30,000 in net profits and would have reported those profits as taxable income. Because Sara’s payment of $30,000 to Laura is a substitute for lost profits, Laura must report the settlement payment as taxable.

The Settlement Agreement

The examples above are fairly straightforward illustrations of how the origin of the claim doctrine works. More complex litigation matters, however, naturally make the federal income tax analysis more difficult. To ensure advantageous tax treatment under a more complex set of facts, it is important to clarify the nature of the payments within the settlement agreement itself.

For example, assume in our example two above that, in addition to damages to her crops, Laura suffered damages to several tractors and a barn. As a means to settle the matter, Sara agrees to pay Laura a lump sum of $250,000, which Laura accepts. Assume further that the settlement agreement is silent concerning the allocation of the $250,000 to Laura’s damages, which now include lost profits (taxable) and recoveries of capital (potentially taxable if the amounts exceed basis or depreciation was claimed on the farm assets). How should Laura allocate the $250,000 lump sum payment to her damages?

Similar to any other tax controversy, taxpayers bear the burden of proving allocations of settlement payments amongst their taxable and non-taxable damages. There are legions of federal court cases where taxpayers have been unable to sustain their burden of proof, resulting in the entire lump sum payment being characterized as taxable. The simplest manner to correct this potential problem is to ensure the parties have agreed on an allocation of the settlement payments. Both the IRS and federal courts respect these types of allocations if negotiations are done in good faith and the parties are adverse.

Another point of negotiation often left out is whether the payor will issue an information return concerning the settlement payment (e.g., Form 1099). There is ample authority that provides that an information return should not be issued by the payor if the payor can’t determine whether the payment represents income to the payee or if the facts and circumstances demonstrate the payment is non-taxable. For example, an argument may be made that Sara should not issue a Form 1099 to Laura for the lost profits because Sara cannot determine with any degree of certainty the true amount of the profit—i.e., Sara doesn’t know Laura’s tax basis in the crops. See, e.g., Rev. Rul. 80-22. Although the issuance or non-issuance of an information return doesn’t necessarily govern the tax consequences (it only serves to alert the IRS), the absence of an information return has been considered by federal courts as a favorable factor in that it evidences the payor’s intent to characterize at least some of the payment as non-taxable. There may be other exceptions to the information return requirements, and I have had some success in convincing defendants’ attorneys of these exceptions in private practice.

Attorneys’ Fees

Perhaps no other issue is more troubling to plaintiffs than the deductibility of attorneys’ fees. Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), many plaintiffs could deduct their attorneys’ fees as miscellaneous itemized deductions (to the extent they were not subject to the alternative minimum tax). The TCJA prohibited miscellaneous itemized deductions for 2018 through 2025, and the One Big Beautiful Bill Act (OBBBA) made these prohibitions permanent for the 2026 and later tax years.

Worse yet, the Supreme Court’s decision in Commissioner v. Banks, 543 U.S. 426 (2005) often makes a recovery of attorneys’ fees from a defendant taxable. The Banks decision rests on assignment of income principles and makes a recovery of attorneys’ fees extremely punitive to plaintiffs.

Example Three: Assume the same facts as Example Two above in that Laura seeks damages of $30,000 of lost profits from Sara. Assume further that Sara agrees to pay Laura $30,000 for lost profits and an additional $30,000 for Laura’s attorneys’ fees. Under Banks, Laura is taxable on the $30,000 recovery of attorneys’ fees. Assuming Laura has no basis in the crops and Laura has a 37% marginal rate, she must pay tax on $60,000, or $22,200. Her ultimate recovery after payment of taxes and attorneys’ fees is therefore $7,800 ($60,000 - $22,200 - $30,000).

Plaintiffs such as Laura are left with few options after the prohibition on miscellaneous itemized deductions and the holding in Banks. There are some statutory provisions that permit an above-the-line deduction for attorneys’ fees. Plaintiffs with damages to capital assets may also be able to capitalize the attorneys’ fees and use them later as an offset against the sale of a capital asset if the facts and circumstances support such a position. Only taxpayers with solely tax-free recoveries—e.g., payments for physical injuries under section 104—are usually spared under Banks.

Conclusion

As discussed above, the federal income tax consequences associated with litigation and settlement payments can be complex. Given the punitive consequences of failing to address the tax consequences in a settlement agreement, taxpayers involved in litigation and settlement negotiations should ensure they have a tax professional reviewing and commenting on the negotiated terms. Whether a taxpayer ultimately succeeds in reducing the federal taxes associated with a settlement agreement will turn primarily on the settlement terms and characterization of the payments as set forth in the agreement.

For questions concerning this blog post or any other civil or criminal tax related matter, please feel free to contact me at mroberts@meadowscollier.com.