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Thursday, December 29, 2005

You Be the Judge - Litigation Settlement Proceeds

Facts: Taxpayer-employee sued his employee for various damages. The employee and the employer settle the lawsuit, and taxpayer-employee is paid $40,000, less tax withholdings. The taxpayer claims the payment was to compensate him for a physical injury so that it was not taxable to him. The settlement agreement between the employer and the employee does not indicate the proceeds were paid to compensate the employee for physical injury.

The Law: Code Section 104(a)(2) provides an exclusion for "the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness."

The Issue: Can the employee deduct the payment if the settlement agreement doesn’t say it was for physical injury?

The Holding: No deduction allowed. The Court noted that a taxpayer seeking to exclude money damages from income bears the burden of proving that the exclusion applies. The fact that the settlement agreement did not indicate the payment was for physical injury meant the taxpayer did not bear his burden of proof.

The Lessons:

a. Make sure your settlement agreement describes what the settlement payment is for, if you are trying to claim that the proceeds received are of a type that are not subject to income tax.

b. Where the settlement agreement is silent, a court may look to the original complaint and pleadings to see what damages the claimant was originally seeking. Make sure your complaint has the description of the claim that you want the settlement proceeds (or indeed, an ultimate court judgment recovery) to be characterized as.

Rivera V. Baker West, Inc., 96 AFTR 2d 2005-XXXX, (CA9), 12/13/2005.

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