Settlement-Related Tax Issues that Litigators and Mediators Should Know About

Negotiations and settlements are an everyday occurrence in the legal profession. Tax implications are often overlooked in settlement discussions and negotiations yet often play a large part of the overall settlement.

The Alternative Dispute Resolution and Tax sections of the San Diego County Bar Association hosted an informative presentation on how certain tax implications must be considered before, during, and after settlement discussions. The presenter, Mitchell B. Dubick of Higgs Fletcher & Mack LLP, provided his perspective on the importance of including tax considerations in settlement agreements.

Preliminary Considerations

Whether you are a litigator or mediator one of the first elements of any settlement discussion needs be tax considerations. Mr. Dubick emphasized that “virtually every transaction has tax consequences,” and the earlier the potential tax implications are reviewed and implemented, the better for both the attorney and client. Early review of proposed settlement terms can provide other opportunities for resolution that will benefit both sides. Mr. Dubick provided an example in which allocations of wages and non-wage penalties during the settlement process can reduce potential taxation in an employment-related case ultimately benefiting both sides.

Use of Tax Professionals

In addition to the early review of potential tax implications, Mr. Dubick strongly advised the use of tax professionals in settlement discussions. The use of tax professionals can often assist both litigators and mediators in avoiding any tax issues that would prevent the eventual settlement of the case. Enlisting the assistance of a tax professional from the outset of negotiations is also a benefit as last-minute reviews can lead to significant changes to key settlement terms. An often-overlooked option is retaining a third-party neutral to advise the parties on tax treatment and other related considerations.

Characterization of Payments

Another area in which a tax professional can assist in the settlement process is in characterizing the payments and providing information on whether the payment is deductible as a business expense. In terms of characterization, the underlying claim is the determining factor. The tax treatment for each payment for the claim will need to be reviewed carefully, as there are unique factors that will determine the different levels of tax treatment. Often multiple claims are alleged, such as personal injury and punitive damages, which can lead to differing tax treatment for the respective settlement payments.

With the completion of each settlement agreement and payment comes the question of what is required to be reported to the taxing authority. Reporting requirements also depend on the nature of the claim. Mr. Dubick discussed cases in which payment for personal injury damages did not require reporting, while payments for business-related matters are generally required. It is important to consider the reportability of each settlement, as failure to report can lead to penalties.

Another frequent issue that often arises is the deductibility of attorney’s fees. Again, depending on the nature of the claim, certain attorney’s fees are deductible as a business expense. However, the determination of the deductibility of the attorney’s fees should be left to a tax professional.

Drafting Issues

As discussed earlier, certain allocations in the settlement agreement are generally beneficial to both sides, however, failing to include the correct allocations in the agreement can lead to issues with the taxing authority. In some instances where there is little to no allocation, the taxing authority can impute its own allocations to the agreement, potentially causing changes in the tax treatment of the settlement payments. Furthermore, tax authorities are not bound by the terms of the settlement agreement and can change the allocations. To avoid the potential change in tax treatment, Mr. Dubick advised that each settlement agreement should, at a minimum, have an arguable basis for the allocations for each of the claims at issue. Tax authorities are more likely to respect the allocations of the settlement agreement when the agreement is drafted to specifically provide for such allocations.

It is important to note that lack of both precision and specificity in drafting settlement agreements can lead to unwanted tax consequences. The potential tax consequences from a poorly drafted settlement agreement can arise at any time, with some not appearing for several years after the settlement agreement was drafted.

Final Takeaways

Tax is an important part of any settlement agreement. Be sure to enlist the assistance of a tax professional early in the settlement process and consult with them frequently throughout the drafting of the agreement. Be as specific as possible, and lay out the allocations of each payment, the reporting obligations, and the overall responsibility of each party.

Mr. Dubick’s presentation “Tax Issues that Litigators and Mediators Should be Aware of with Respect to Settlements” is available on-demand through the San Diego County Bar Association.