Tax Hits College Admissions Scandal, IRS On Notice

It’s almost Tax Day. Unless you’ve had your head in the sand, it would be hard not to know something about the college admissions scandal. Prosecutors charged 50 people in an alleged scheme to secure spots at top universities by illicit means, from fixing test scores, to faking athletic prowess, to rigging donations. The charges have yet to be proven, but the 33 parents who are charged will have to contend with cooperating witnesses, including the alleged mastermind of the scheme, William Singer. He has already pleaded guilty to counts of racketeering conspiracy, money laundering conspiracy, conspiracy to defraud the United States, and obstruction of justice. How do taxes figure in?

Members of the media and attendees gather as actress Lori Loughlin, not pictured, exits federal court in Boston, Massachusetts, U.S., on Wednesday, April 3, 2019. Wealthy parents appeared in court as the clock ticks down on plea bargains for their alleged role in the biggest college admissions scam the Justice Department has ever prosecuted. Photographer: Scott Eisen/Bloomberg photocredit: © 2019 Bloomberg Finance LP

A number of parents were charged with conspiracy to commit mail fraud and honest services mail fraud. Prison time is certainly possible. But the tax elements of the case are now getting some press. This week, U.S. Senate Finance Committee Chairman Chuck Grassley (R-IA) and Ranking Member Ron Wyden (D-OR) called on the IRS Commissioner in this letter to fully enforce the tax laws against those involved. Perhaps Republicans and Democrats can agree on something after all. They outline several types of transactions between parents and the Key Worldwide Foundation to facilitate the illicit payments. These include payments made from private foundations and from businesses for what appear to be personal, illicit benefit, as well as donations of stock arranged to appear as charitable donations. The tax angles are huge, and the potential taxes, penalties and interest seem serious. Criminal tax charges are possible, and they could be serious in themselves.

The tax law is clear that you can’t write off a charitable contribution if it wasn’t really a charitable contribution. One way it might not be is if you were paying for services. Another way would be if the charitable entity wasn’t really charitable. Still another might be linked to where the money you contributed came from originally. The Senate Finance letter points out that several of the parents involved in the scandal may have misappropriated funds from private foundations over which they have financial control in order to make illicit payments to the Key Worldwide Foundation. There are tight tax law controls over how private foundations spend money, with special restrictions on so-called self-dealing transactions.

But the tax issues don’t stop there. An Affidavit in the case alleges that some of the parents paid bribes and other payments from accounts associated with their businesses. For example, the Affidavit describes one defendant father asking the scandal’s ringleader, “What are the options for the payment? Can we make it for consulting or whatever from the [K]ey so that I can pay it from the corporate account? [Ringleader] replied that he could make the invoice for business consulting fees, so that [father] could ‘write off as an expense.’ [Father] replied, ‘Awesome!’”

Shortly thereafter, the defendant father’s company allegedly wired $100,000 to Key Worldwide Foundation. The Senators say this strongly suggests the payments were not legitimate business expense deductions. Willfulness or knowledge of wrongdoing can be hard for the government to prove in a criminal tax case. But it may be hard to argue that these tax mistakes were unintentional. Then, there is the alleged end-run around capital gain taxes. The Senators point to the Affidavit again, which suggests that some parents made stock donations. Why stock? That way, you get a write-off for the market value of the stock, and don’t have to pay the capital gain tax on the appreciation in the shares. Talk about a double tax benefit! There are many aspects to this case, but taxes could play a large part. And the people involved are likely to be doing some damage control with amended tax returns and disclosures to the IRS and state tax authorities on top of everything else.

via Robert W. Wood


5 Reasons Not To File Taxes April 15 & Extend (Hint, Reduce Audit Risk Is One)

Tax returns are due April 15. But instead of rushing to file your taxes, you can go on extension. It is automatic on request, and incredibly easy to do. But should you? It is awfully tempting to succumb to the allure of an extra six months, but there are those nagging questions. If you extend, do you increase your odds of audit. Conversely, maybe you actually decrease your audit odds, or are they the same? We’ll come back to that question. For most people, few deadlines are more dreaded than the annual rush to April 15th. Many people do not want to put off that deadline, since getting past it can seem like such a watershed event every year. In fact, some people may even feel guilty if they take advantage of that tempting automatic six-month reprieve.

Red pushpin on day of April 15 of calendar for tax income due date reminder with pencil and currency in background photocredit: Getty

There’s no shame in an extension, and millions of them are processed every year. Everyone with an April 15 deadline can automatically get six extra months by filing (electronically or by mail) a tiny form. It doesn’t even require a signature. It couldn’t be easier. Of course, the extension is to file your tax return, it is not an extension of time to pay. Thus, you need to pay by April 15 what you expect to owe when you actually file your taxes later in the year, anytime up until October 15th. But are there good reasons to take the extension? You bet.

Going on extension encourages reflection. Many returns around April 15th are filed in haste, some carelessly. And that can bring on an audit. Extensions can allow the the time to gather records, consider reporting alternatives, and get professional advice. After all, tax returns must be signed and filed under penalties of perjury. It is best to file accurately so you don’t have to amend later. Amended returns often come about because people are in a rush. Amending isn’t necessarily bad, of course. There are times you may want or need to amend your return. But try to use amended returns sparingly. For one thing, amended returns are much more likely to be scrutinized. File once correctly so you do not need to do it again.

The IRS doesn’t have to approve the extension. It is automatic, and there is no discretion involved. You automatically get the extra six months, period. Extensions used to be four months, with two additional months only if you had a good reason. But now, automatic extensions are for a full six months. You may not need all that time, and once you extend, you can file whenever you would like between April 15 and October 15. That time comes in useful in other ways too. For example, going on extension also allows for corrected Forms 1099 and K-1. You may be waiting for Forms K-1, gathering documents or seeking professional advice. Time is on your side with an extension.

If there are debatable points on your return, such as whether a litigation recovery is ordinary or capital, take the time to get some professional advice. Besides, even if you have all your forms ready, what if you receive a Form K-1 or 1099 after you file? It happens a lot, and the earlier you file your return, the greater the risk you will receive corrected forms that may make you need to amend. Going on extension makes it less likely that you will be surprised by a tardy corrected Form K-1 or 1099. You may as well file once and file correctly.

And then there are all the stories about audit risk. Some people say that going on extension increases audit risk, while some people say the opposite. There appears to be no hard evidence to prove either theory. However, it is worth stressing that there is no evidence that there is an increased audit risk if you go on extension. In fact, on the contrary, given all the advantages of an extension, one can argue that an extension can actually help reduce your audit risk. Of course, all taxpayers worry about IRS audit risk. Opinions vary, and there are many old wives tales about what triggers an audit.

However, it is unlikely that going on extension increases IRS audit riskThe IRS releases data about audit rates based on income levels and types of tax returns. The IRS does not release data about whether going on extension increases or decreases your chances. But I still say extensions encourage reflection and care, and that alone reduces audit risk. So, going on extension if you need the time can just make sense. To extend, you can submit a Form 4868, ask your tax return preparer, use commercial software, or do it yourself electronically. For more guidance, check out IRS tax topic 304, covering extensions of time to file your tax return.

via Robert W. Wood

$80M Roundup Verdict Is Only $2.5M After Taxes, New IRS Math

Another Roundup verdict is in. This time, jurors found that Monsanto failed to warn users its product was dangerous and awarded Edwin Hardeman $200,000 for economic losses, $5 million for past and future pain and suffering, and $75 million in punitive damages. Last year, jurors gave $289 million to a man they say got cancer from Monsanto’s Roundup. That verdict was later reduced, and is on appeal. But the latest case is federal, and suggests that others could be headed for big numbers. The jury had already concluded that the weedkiller was a substantial factor in causing Mr. Hardeman’s non-Hodgkins lymphoma. Monsanto faces over 10,000 claims, and can be expected to continue fighting hard. But even if Monsanto pays up, new tax rules could swallow up many of the verdicts plaintiffs might be hoping to collect. Wait until you see the new tax math.

(AP Photo/Paul Sakuma) photocredit: ASSOCIATED PRESS

Under President Trump’s tax bill passed in late 2017, there is a new tax on litigation settlements: no deduction for legal fees. Amazingly, many legal fees can no longer be deducted. That means many plaintiffs must pay taxes even on monies their attorneys collect. Of course, the attorneys must also pay tax on the same money. Here’s the new math. Hardeman was awarded a bit over $5 million in compensatory damages, and $75M in punitive damages. The combined contingent fees and costs Mr. Hardeman pays his attorneys might total as much as 50%. If so, the plaintiff would get to keep half, or $2.5 million of the $5 million compensatory award. Since it is for his claimed non-Hodgkin’s lymphoma, that part for physical injuries should not be taxed. Then, of the $75 million punitive award, $37.5 million goes to legal fees and costs, and $37.5 million to Hardeman. So before taxes, the plaintiff’s take home is $40 million.

What about after taxes? The $75 million in punitive damages are fully taxable, with no deduction for the fees to his lawyer. Between federal taxes of 37% and California taxes of up to 13.3%, Hardeman could lose about 50% to the IRS and California Franchise Tax Board. That makes his after-tax (and after legal fee) haul from an $80 million verdict only $2.5 million. Does that seem fair? $2.5 million isn’t pocket change, but it is still a shocking result. Besides, being taxed on money you do not receive seems downright un-American. The shocking result comes from the Trump tax law, which kills off tax deductions for many legal fees. Notably, compensatory damages for physical injuries or physical sickness are still tax-free.

However, exactly what injuries are “physical” can sometimes seem like a chicken or egg issue. And when punitive damages or interest enter the picture, many plaintiffs simply cannot deduct the related legal fees, so are taxed on their gross, even if the lawyer is paid first. According to the Supreme Court, if you are the plaintiff with a contingent fee lawyer, the IRS treats you as receiving 100% of the settlement or judgement, even if the defendant pays your lawyer directly. If your case is fully nontaxable, that causes no tax problems. But if your recovery is taxable, all or in part, you could be taxed on more money that you actually collect. Up until the end of 2017, you could claim a tax deduction for your legal fees.

In 2018 and after, there is no deduction for these legal fees. At least not all lawyers’ fees face this terrible tax treatment. If the lawsuit concerns the plaintiffs’ trade or business, the legal fees are a business expense. If your case involves claims against your employer, or certain whistleblower claims, those legal fees are also still deductible. But in other cases, you are out of luck unless you are awfully creative. There are sometimes ways to circumvent these tax rules, but you’ll need sophisticated tax help, and nothing is foolproof. Settlements require advice on the taxation of damage awards, preferably before the case settles. Plaintiffs may have to be creative to try to get around these rules, so tax lawyers are busy. So are lawyers in both sides of the Roundup cases.

via Robert W. Wood

Roundup Weedkiller Verdicts Draw IRS Taxes, Here’s Why

Monsanto could be facing more than a few significant verdicts in its unfolding Roundup weedkiller litigation. Last year, jurors gave $289 million to a man they say got cancer from Monsanto’s Roundup. That verdict was later reduced, but another bellwether case could be headed for big numbers. A second California jury has already concluded that the weedkiller was a substantial factor in causing non-Hodgkins lymphoma in Edwin Hardeman, a 70-year-old man who used Roundup. It is starting to look as if the dominoes are lined up and beginning to fall, and there are many other Roundup cases in the works. Monsanto faces hundreds of claims, and can be expected to continue fighting hard. It might seem premature to think about taxes, but they could figure into the mess in a curious way. For even if Monsanto forks over the money, new tax rules could swallow up some of the verdicts plaintiffs might be hoping to collect.

A bottle of Roundup by Monsanto Co. is shown in a weeded area in Palo Alto, Calif., Wednesday, June 30, 2010. Monsanto Co., the world’s biggest seed maker, said Wednesday its fiscal third-quarter net income tumbled 45 percent as it shrank its Roundup weedkiller business amid intense generic competition. (AP Photo/Paul Sakuma) photocredit: ASSOCIATED PRESS

Under the big tax law passed in late 2017, there is a new tax on litigation settlements: no deduction for legal fees. That’s right, many legal fees can no longer be deducted, forcing some plaintiffs to pay tax even on monies their attorneys collect. That is so even though the attorney must also pay tax on the same money. The math can seem hard to justify. If you are a plaintiff with a contingent fee lawyer, the IRS treats you as receiving 100% of the money, even if the defendant pays your lawyer directly. If your case is fully nontaxable, that causes no tax problems. Say you sue Monsanto, claiming that the company gave you cancer. Let’s say you collect compensatory damages in the amount of $10M. Let’s assume your lawyer takes 40%. That means you end up with $6M. Whether you view the total recovery as $10M or $6M doesn’t really matter. With only compensatory damages, the whole $6M should hopefully be tax free. IRS rules clearly say that you can’t deduct the $4M in legal fees. But you don’t need to, since the whole thing should be nontaxable.

There is a big tax problem, though, if punitive damages or interest are awarded. Many weedkiller cases involve requests for big punitive damages. So on top of $10M in compensatory damages, suppose that you are awarded $40M in punitive damages? Let’s assume the same 40% legal fee. That means you net $30M, and your lawyer takes home $20M. For what is taxable, you must separate the two damages. Let’s assume your $10M in compensatory damages is tax free. You get $6M of that, and your lawyer gets $4M. For the punitive part, you net $24M after fees.

But a shocking change in the Trump tax law eliminated tax deductions for many legal fees. Compensatory damages for physical injuries or physical sickness are still tax free, although exactly what injuries are “physical” can sometimes seem like a chicken or egg issue. Here, although you only get to keep $24M of your punitive damages, you are taxed on the whole $40M. In total, you collect $30M, but are taxed on $40M. These seemingly topsy-turvy numbers can get even worse if there are costs to consider on top of the legal fees (there usually are), or if the contingent fee is higher than 40%. In short, if a recovery is taxable, all or in part, the plaintiff can be taxed on more money than he actually collects.

Not all lawyers’ fees face this bizarre tax treatment. If the lawsuit concerns the plaintiffs’ trade or business, the legal fees are a business expense. Also, if your case involves claims against your employer, or certain whistleblower claims, those legal fees are also still deductible. But for other cases, you are out of luck unless you are awfully creative. Increasingly, legal settlements require advice on the taxation of damage awards, preferably before the case settles. There are some ideas how to address this new tax on litigation settlements here, but you’ll need professional tax help and nothing is foolproof.

via Robert W. Wood

Keep IRS From Taking Your Passport, Here’s How

The IRS recently reiterated its warning that taxpayers may not be able to renew their passports or get a new one if they owe $52,000 or more in federal taxes. In January of 2018, the IRS began implementing new procedures for individuals with “seriously delinquent tax debts.” If you have seriously delinquent tax debt, IRS can notify the State Department. The State Department generally will not issue or renew a passport after receiving a certification from the IRS. The IRS can’t take your passport exactly, but it can tell the State Department to do so. Whether this is a good idea can be debated, but it is the law. It wasn’t even an executive order that did it. The change in the law came in the Fixing America’s Surface Transportation (FAST) Act, adding Section 7345 to the tax code. It isn’t limited to criminal tax cases, or even cases where the IRS thinks you are trying to flee. The idea was proposed and rejected in 2012. But by late 2015, Congress passed it and President Obama signed it.

photocredit: Getty

Here are steps you can take to hang onto your passport:

  1. Don’t be ‘seriously delinquent.’ A seriously delinquent tax debt is a key term. If you don’t have one, your passport is safe. So if you must owe, keep your debt below $52,000. But that includes penalties and interest, so beware. A $20,000 tax debt could eventually grow to $52,000. And be careful, once your tax debt is labeled ‘seriously delinquent,’ you paying it down to $51,999 may not help. The IRS will not reverse a certification because the taxpayer pays the debt below $52,000.
  1. Keep your dispute with IRS going. You can usually contest tax bills if you do so promptly. The IRS usually sends multiple notices for any tax debt, and you should respond. Explain why the IRS is incorrect, and keep protesting. If you receive an IRS Notice of Proposed Deficiency or Examination Report, respond. It is sometimes called a “30-day letter,” because of the deadline for response. Prepare a protest, and sign and mail it before the deadline. Keep a copy, and proof of mailing, preferably certified mail. Normally a protest will land you in the IRS Appeals Office, where you have another chance to resolve it.
  1. Go to Tax Court. If you fail to protest or you don’t resolve your case at IRS Appeals, you probably will receive a Notice of Deficiency. An IRS Notice of Deficiency comes via certified mail. It is often called a “90-day letter,” because you have 90 days to respond. Only one response to a Notice of Deficiency is permitted: filing a Tax Court petition in the U.S. Tax Court clerk’s office in Washington, D.C. The U.S. Tax Court cannot hear your case if you miss the 90-day deadline. You want to keep your tax dispute going so the tax debt does not become final.
  1. Get extensions. You can sometimes get extensions from the IRS, so keep communicating. For many notices, the IRS will grant an extension of time to respond. In some cases, though, they can’t. For example, when you receive a Notice of Deficiency (90-day letter), you must file in Tax Court within 90 days, and this date cannot be extended. Most other notices are less strict. If you do ask for an extension, confirm it in writing. In fact, confirm everything you do with the IRS in writing.
  1. Communicate with IRS. If you get a certification that your debt is ‘seriously delinquent’ contact the phone number listed on the IRS Notice. If you’ve already paid the tax debt, send proof to the address on the Notice.
  1. Prove you need your passport. If you need your U.S. passport to keep your job, once your seriously delinquent tax debt is certified, you must fully pay the balance, or make an alternative payment arrangement to keep your passport. Once you’ve resolved your tax problem with the IRS, the IRS will reverse the certification within 30 days of resolving the issue.
  1. Make an installment agreement. It is often not too hard to get an installment agreement with the IRS to pay your tax debt over time. If you sign one, stick to its terms. Even if your debt is huge, the IRS doesn’t call it ‘seriously delinquent’ if you are paying the installments on time.
  1. Offer in compromise or settlement. You can also try this route too to settle with the IRS. If the IRS accepts an offer in compromise to satisfy the debt, the rest of it can be forgiven. In some cases, the Justice Department too can enter into a settlement agreement to satisfy a tax debt.
  1. Innocent spouse relief. If the tax debt was your spouse’s, and you are saddled with it because of joint tax returns, you might qualify for innocent spouse treatment. This is a separate big topic, and rules are more complex than you might think. See IRS Tax Topic 205, Innocent Spouse Relief. However, it’s significant that the IRS can suspend collection efforts if you request innocent spouse relief (under IRC Section 6015). 
  1. Due process. There are many taxpayer protections when it comes to IRS collections. One set of protections is collection due process hearings. If you make a timely request for a collection due process hearing in connection with a levy to collect the debt, you may at least buy time to work out a deal with the IRS. See Taxpayer Advocate 2016 Annual Report to Congress, Appeals From Collection Due Process Hearings Under IRC §§ 6320 and 6330.

via Robert W. Wood

Tax Pointers From Manafort To Avoid IRS And Jail

First, former Trump campaign chairman Paul Manafort was convicted on eight counts, the first conviction for Special Counsel Robert Mueller. Then, he was sentenced to 47 months in prison, a sentence many say was too light. Prosecutors wanted a lot more jail time, and the Sentencing Guidelines suggested that a lot more time was probable. No one wants to be jailed over taxes. And in that sense, regardless of what you think of the sentence, there are a few lessons for more regular taxpayers. Most obviously, declare all your income and foreign accounts, and don’t obscure or cover up the facts. You can make mistakes, but your mistake must be credible. If there are too many oversights or glitches, you might just appear to be willful. Negligence, inadvertence, or mistake is OK. Intent to conceal or to evade taxes is not. The IRS says this, as in this statement from the IRS’s Streamlined disclosure program:

Police handcuffs lie on the tax form 1040. The concept of problems with the law in the aftermath of non-payment of taxes photocredit: Getty

Provide specific reasons for your failure to report all income, pay all tax, and submit all required information returns, including FBARs. If you relied on a professional advisor, provide the name, address, and telephone number of the advisor and a summary of the advice. If married taxpayers submitting a joint certification have different reasons, provide the individual reasons for each spouse separately in the statement of facts.”

If you knew you were supposed to report, the IRS may say you were willful. What’s more, the IRS uses a concept of “willful blindness.”
Essentially, it is a conscious effort to avoid learning about the IRS or FBAR reporting. Willfulness involves a voluntary, intentional violation of a known legal duty. In taxes, it applies for civil and criminal violations. The failure to learn of filing requirements, coupled with efforts to conceal the facts, can spell willfulness.

What else should you avoid? Avoid setting up trusts or corporations to hide your ownership. Avoid filing some tax forms and not others. Avoid keeping two sets of books. Avoid telling your bank not to send statements. Avoid using code words over the phone. Avoid cash deposits and cash withdrawals. Even if you can explain one failure to comply, repeated failures can morph conduct from inadvertent neglect into reckless or deliberate disregard.

The IRS requires you to report your worldwide income on your taxes, and to report your foreign accounts. There might be some temptation to hidden accounts. But FBARs, the foreign bank account reporting form Manafort failed to file, have been required by law since 1970. It is very easy for the government to win FBAR cases, and the penalties–both civil and criminal–are steep, worse than tax evasion. The IRS and Justice Department took on Swiss banking, and won big in court. UBS settled with the U.S. government in 2009 for $780 million. Since then, vast numbers of Swiss and other banks faced criminal charges or made big civil settlements. And American taxpayers have too, with IRS offshore account collections haul topping $10 billion. For ten years, the IRS ran its Offshore Voluntary Disclosure Program, a type of tax amnesty that formally closed on September 28, 2018. The IRS Streamlined program still exists, but Streamlined cases are subject to audits. 

Now the IRS has a new IRS offshore account policy with bigger penalties. Manafort probably wishes he had cleaned up his accounts voluntarily before he was in the government’s cross hairs. Another lesson is about IRS access to information, and the many avenues the IRS has to stay ahead of taxpayers. Consider FATCAthe Foreign Account Tax Compliance Act. It penalizes foreign banks if they don’t hand over Americans. The vast majority of foreign countries and their banks comply, so don’t count on bank secrecy anywhere. On top of FATCA, the U.S. has a treasure trove of data from 50,000 voluntary disclosures, whistleblowers, banks under investigation and cooperative witnesses. So the smart money suggests resolving your issues. You can have money and investments anywhere in the world as long as you disclose them.

via Robert W. Wood

IRS Gives Tax Break To Sexual Harassment Victims

The tax reform law passed in December 2017 prohibits tax deductions for hush money settlements in sexual harassment cases. Sometimes called a Weinstein tax, it prevents individuals and companies from writing off the settlements and related legal fees. But the law seems to say that plaintiffs too cannot deduct their legal fees. If a plaintiff recovers $500,000 but must pay her lawyer 40%, the full $500,000 is income, even though the plaintiff nets only $300,000. The victim is paying tax on money she never receives. Of course, the legal fees are taxable to the lawyer too, who must also pay taxes. Some people call that double taxation. But more importantly, why penalize the poor plaintiff in the first place? The Weinstein tax was supposed to punish the defendant, not the plaintiff. There has been a lot of tax worry about this.

But fortunately, the IRS has posted an FAQ on the IRS website giving notice that it has fixed this problem, even if Congress can’t seem to. The IRS asks this Question: “Does section 162(q) [the Weinstein tax] preclude me from deducting my attorney’s fees related to the settlement of my sexual harassment claim if the settlement is subject to a nondisclosure agreement?” Answer: “No, recipients of settlements or payments related to sexual harassment or sexual abuse, whose settlement or payment is subject to a nondisclosure agreement, are not precluded by section 162(q) from deducting attorney’s fees related to the settlement or payment, if otherwise deductible.”

A close up of a ballpoint pen and a calculator resting on top of an IRS 1040 income tax return. photocredit: Getty

That is awfully welcome relief, particularly since the technical correction that some members of Congress moved to enact didn’t go anywhere. The “Repeal the Trump Tax Hike on Victims of Sexual Harassment Act of 2018” was proposed, but seemed to die on the vine. Bravo to the IRS for fixing what Congress didn’t. Of course, plaintiffs still have tax problems. After all, just about everything is taxed. Sexual harassment might be verbal, physical or both, and it might impact victims in a variety of ways. The tax treatment of litigation damages is varied and complex. But the rule for compensatory damages for personal physical injuries is supposed to be easy. They are tax free under Section 104 of the tax code. Yet exactly what is “physical” isn’t clear. For that reason, many sexual harassment victims where there is little or no physical contact usually have to pay taxes on their recoveries. Some of it seems to be semantics. If you make claims for emotional distress, your damages are taxable. If you claim the defendant caused you to become physically sick, those damages can be tax free. If emotional distress causes you to be physically sick, that is taxable. The order of events and how you describe them matters to the IRS. If you are physically sick or physically injured, and your sickness or injury produces emotional distress, those emotional distress damages should be tax free.

Wording in the settlement agreement is important, and so are IRS Form 1099. But emotional distress is taxable, and that includes physical symptoms, such as insomnia, headaches, and stomach disorders, which can result from emotional distress. So says H. Conf. Rept. 104-737. Tax free money is better than taxable money, and the wording in settlement agreements can sometimes matter in a very big way. However, you don’t want to face claims by the IRS or state tax authorities several years later, adding interest and penalties. Notably, plaintiffs who use contingent fee lawyers are treated as receiving 100% of the settlement, even if their lawyer takes 40% off the top. The Supreme Court said so in Commissioner v. Banks, 543 U.S. 426 (2005). That means plaintiffs must figure a way to deduct the fees, which the IRS has just confirmed they can in the recent FAQ.

Whenever possible, it is advisable for plaintiffs to get some tax advice before a settlement is documented. The IRS isn’t bound by the parties’ tax characterization, but it is often respected if reasonable. Besides, once the documents are signed it will be too late to try to address it. The interactions between physical and emotional injuries and sicknesses are starting to be explored. Some plaintiffs in employment suits have had settlements classified as tax-free. In one case, stress at work produced a heart attack, physical sickness that qualified for tax free treatment. In another case, stressful conditions made a worker’s pre-existing multiple sclerosis worse, and that too was considered tax-free physical sickness. Former President Obama once suggested that PTSD may be physical too.

via Robert W. Wood