The following article is reprinted from The M&A Tax Report, Vol. 12, No. 10, May 2004, Panel Publishers, New York, NY.


By Robert W. Wood and Dominic L. Daher

When a lawsuit is settled and a corporation is the defendant, there are a host of tax considerations that should be taken into account. Most corporate counsel have been involved in disputed matters where the plaintiff insists on a certain tax characterization (for example, a recovery excludable as physical injury damages). How to respond to this query, as well as various other pitfalls, deserves attention.


The first thing that should concern corporate counsel on payment of a settlement amount (or a judgment) is whether the payment is deductible. Of course, in the vast majority of litigation arising in a business, the payment (together with associated attorneys' fees) will be deductible. There are only a couple of exceptions, and all of these are of limited application. The first and perhaps most difficult to understand is the requirement that in some cases a settlement payment (and the associated legal fees) must be capitalized. Usually these relate to particular kinds of suits over capitalized assets. For example, a lawsuit over an acquisition, a lawsuit over title to the corporation's property. The IRS takes the position that in these cases the expense must be capitalized over the life of the asset.

Another major area in which a deduction may be questioned is where the payment is in the nature of a fine or penalty. Under Internal Revenue Code Section 162(f), the payment of a fine or penalty is nondeductible. Note that this only applies to payment to a governmental entities. Punitive damages paid to private parties are fully deductible. Indeed, even if a payment is to a governmental entity and looks to be a fine or penalty, a deduction may still be available in some cases.

Surprisingly, there is significant case law dealing with the topic of whether a fine or penalty is really intended to be punitive (in which case the payment is nondeductible) or is instead remedial in nature. Environmental payments and a variety of other sorts of payments to governments and quasi-governmental entities have been examined in this context. Corporate counsel should certainly be alert to anything that carries the "fine or penalty" moniker before making any payments. Sometimes it is possible to enter into a settlement agreement with the governmental agency in question specifying that the payment is remedial rather than punitive in character.

In the "danger of nondeductibility" category, we should also list personal expenses. This doesn't come up too often in the corporate context. Yet, there have been a few cases where persons in a business setting thought they could deduct payments, but they were ruled to be nondeductible by the company. If a company pays its CEO's divorce litigation expenses (or settlement), for example, the IRS (and the courts) have not been sympathetic (big shocker!). These are purely personal matters, even if the corporation may see itself as protecting its assets.

There have been few cases in which the same has occurred with sexual harassment cases. Although no company likes to see sexual harassment suits, the overwhelming majority of these suits are, without any question, deducted by the paying company, even if the conduct of the executive or worker involved is outside the course and scope of his or her employment (as it almost always will be).

Withholding Concerns

As all companies know, payments that are in the nature of wages are subject to withholding requirements for federal income tax, social security and unemployment tax, and generally state income and employment taxes as well. If a lawsuit is brought regarding some kind of employment discrimination or wrongful termination, and a settlement is reached, the question is what portion of the settlement ought to be treated as wages. There is no easy answer.

As far as the IRS is concerned, it does not matter that the worker has not been employed by the company for many years. Sometimes litigation takes five years or more to resolve. The mere duration of time does not turn something that was wages into something else. Generally, companies look to what the parties requested in their litigation documents (briefs, mediation briefs, experts reports, etc.).

Example: Suppose the plaintiff claims that the wage loss in a million dollar suit amounts to $400,000, and the defendant claims that the wage loss amounts to only $200,000. If the suit ends up settling for $800,000, then it would seem that a minimum of $200,000 should be allocated to wages. Very frequently the other side's expert testimony (or damage study) can be useful in arriving at tax characterization decisions.

A word should be said about penalties a company may face. The penalty for failure to withhold is significant, and the indemnity provisions that are typically put into settlement agreements (requiring the plaintiff to indemnify the paying company for taxes) are rarely, if ever, invoked by paying companies. Typically the employee does not have much money to chase, and the employer is generally reluctant to get involved in a subsequent legal proceeding in any event. It is important to make this withholding determination before the case is fully resolved.

If an employer fails to deduct and withhold the requisite amounts from an employee's (or former employee's) wages, the employer is liable for the amount of the tax that should have been deducted and withheld. § 3403; Treas. Reg. § 31.3102-1(c) (FICA), Treas. Reg. § 31.3403-1 (income tax). But, if the employer fails to deduct and withhold income tax from wages, it may be relieved of liability for the tax if the employer can show that the tax has been otherwise paid, such as when the employee filed his tax return and paid the tax. This does not relieve the employer of liability for other penalties or additions to tax imposed because of the failure to withhold. § 3402(d); Treas. Reg. § 31.3402(d)-1.

Moreover, if an employer fails to pay any tax which should have been shown on Form 940 (FUTA) or Form 941 (FICA and income tax withholding), but which was not, the employer must pay the tax within ten days after the Service serves a notice and demand for payment. If the employer does not pay within the allotted period, an addition to the tax equal to 0.5% of the amount of the tax for each month the tax remains unpaid, up to 25%, will be assessed. § 6651(a)(2) and (3).

An additional penalty of up to 10% may be imposed by Code Section 6656(a) for failure to deposit employment taxes (employee's withholding and FICA), unless it is shown that such failure is due to reasonable cause and not due to willful neglect. Moreover, if any amount of tax required to be paid is not paid by its due date, interest will accrue on the amount owing. § 6601(a). Interest will also accrue on any penalties or additions to tax assessed as a result of a failure to collect and pay employment taxes or to report as required. § 6601(e)(2).

If the failure to pay any tax due, including employment taxes, is on account of negligence or fraud, additional penalties may be asserted under Code Sections 6662 or 6663. If any part of any underpayment of tax is due to negligence or disregard of the rules, there will be added to the tax the sum of 20% of the total underpayment (even any part not attributable to negligence) and 50% of the interest under Code Section 6601 on that part of the underpayment attributable to the negligence. § 6662(a). The definition of negligence includes the failure to make reasonable attempts to comply with the law. § 6662(c).

If any part of the underpayment is due to fraud, the addition to tax is the sum of 75% of the underpayment due to fraud and 50% of the Section 6601 interest on the part of the underpayment due to fraud. § 6663(a). If fraud is established, all of the underpayment will be presumed to be due to fraud, except for any part the taxpayer can show is not attributable to fraud. § 6663(b). The elements of fraud include an actual, intentional wrongdoing with an intent to evade a tax believed owing; fraud may not be presumed, especially not from a failure to report income alone.

At the same time, while the penalties for failing to withhold are severe (you might even say punitive), the reporting penalties (penalties for failure to issue an IRS Form 1099) are not. That brings us to our next topic.

Reporting (Form 1099) Obligations

In settling a dispute, if an amount is subject to wage withholding, as noted above, there should be tax withholding and the employer should send a Form W-2 to the IRS and the plaintiff. If an amount is paid as general damages, punitive damages, or most other kinds of damages, it is subject to the general rule that a Form 1099 should be issued for the amount of the payment. Here is where a great deal of confusion has arisen concerning reporting obligations.

First, let's be clear on one thing that is not subject to 1099 reporting: a payment for physical injuries or physical illnesses. Thus, if your company pays someone $10,000 who slipped and fell in company headquarters and was physically injured, that $10,000 is not includable in the recipient's income and you need not issue a 1099. The IRS instructions to Form 1099 specifically so state.

What happens, though, when you have a mixed claim, say a sexual harassment claim where there was physical touching and some physical injury (such as a sexual assault and battery), but far more damages for other elements? There is almost no guidance yet on exactly what the physical illness/physical injury requirement of Section 104 (as amended in 1996) truly means. Most defendants try to engage in good faith bargaining over what elements of the payment should be (if any) attributed to the physical illness/physical injury element. If the defendant has a good faith basis for making this determination (the defendant may insist on an opinion from the plaintiff's counsel), then the portion so allocated should arguably be excludable from the plaintiff's income and no IRS Form 1099 would be required. A Form 1099 should be issued for everything else (again, except for withholding amounts, which would be the subject of a W-2).

Suppose the company is wrong about its obligation to issue a Form 1099? The penalty is surprisingly small, assuming the company is wrong, but not intentionally so. The basic penalty for failure to issue a Form 1099 is $50 per failure. See I.R.C. §6721.

A second penalty applies to failures to file Form 1099 only in cases of willful or intentional failures to file Forms 1099. I.R.C. §6721(e). This penalty is equal to the greater of $100 or 10% of the aggregate amount of items required to be reported. Id. My experience may be atypical, but in my 25 years of practice I have never seen the IRS successfully assert this penalty. Of course, there is a threshold question in this circumstance whether the choice to not issue the plaintiffs Forms 1099-MISC for their share of the attorneys' fees could possibly be considered a willful or intentional "failure" to file such form. There is a separate penalty for failure to include correct information on an information return, or the inclusion of incorrect information. I.R.C. §6722. This penalty is also $50 per failure.

Finally, Section 6722(c) imposes an intentional disregard penalty for information returns which are incorrect and where the reporting person has intentionally disregarded the information return rules. As in the case of the penalty for willful failures to file Forms 1099, this penalty is equal to the greater of $100 or 10% of the aggregate amount of items required to be reported. I.R.C. §6722(c). Again, as I noted with respect to the §6721(e) penalty (discussed above), I have never in my 25 years of practice seen the IRS successfully assert this penalty, even outside the damages/settlements area.

It is clear from the regulations that inconsequential errors and omissions will not trigger even the basic $50 penalty for failures to furnish correct payee information. Treas. Reg. §301.6722-1(b). It follows that the willfulness penalty also applies only where there has been a failure that is beyond this inconsequential error or omission standard. Merely reporting the payments to the attorneys as gross income to them (rather than both the attorneys and the plaintiffs) would probably not be considered a failure to furnish correct information. See Treas. Reg. §301.6722-1(b).

Indeed, the Internal Revenue Code itself provides specific reasonable cause abatement provisions. The above-discussed penalties for information reporting failures may be waived if the filer (in this case, the defendants), can establish that the failure is due to reasonable cause and not to willful neglect. I.R.C. §6724. The regulations provide that a penalty will be waived for reasonable cause if the filer can establish that either: (a) there are significant mitigating factors with respect to the failure; or (b) the failure arose from events beyond the filer's control. Treas. Reg. §301.6724-1(a)(2).

The "significant mitigating factors" which can result in a penalty being waived include (among other factors), the established history of compliance of the filer. Treas. Reg. §301.6724-1(b). In addition to establishing a bases for reasonable cause waiver (either significant mitigating factors or events beyond the filer's control), it would be necessary to show that the filer acted in a responsible manner. The regulations suggest that what is necessary is simply reasonable care, doing what a reasonably prudent person would do under the circumstances in the course of its business in determining its filing obligations. Treas. Reg. §301.6724-1(d)(1)(i). Reasonable care would include seeking professional advice, which most corporations certainly have done.

Until We Meet Again

The tax issues affecting a settlement or judgment are usually not the most important issues in a settlement. On the other hand, they are all too frequently left to the very last minute or, worse yet, ignored entirely. Since the tax swing on a settlement can make the difference whether the case is resolved or not, corporate counsel should pay close attention to these rules.

Corporate Lawsuit Settlements — What to Watch for and How Not to Get Burned, by Robert W. Wood and Dominic L. Daher, Vol. 12, No. 10, The M&A Tax Report (May 2004), p. 5.