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The tax treatment of litigation damages is varied and complex. Worse still, in some cases Legal fees cannot be deducted. This may mean that you have to pay 100% taxes, even if 40% of it goes to your lawyer, unless you qualify for one of the Opportunities to deduct legal fees under the new tax law. The rules for compensation for personal injuries, such as those caused by a serious car accident, are actually simple. The compensation should be tax-free according to Paragraph 104 of the German Tax Code.

In employment disputes, damages are usually taxable and are usually paid at least partially as wages. Almost every employment dispute has a wage component. In most employment disputes, the employer and employee agree on an amount of wages that can be withheld, and the remainder is entered on a Form 1099. Sometimes there may be a tax-free portion as well. What exactly is “physical” is not so clear, and some of it seems like semantics. If you make claims for emotional distress, your damages are taxable.

Part of the boundary comes from a footnote in the legislative history of the tax law that adds the “physical” requirement. It states that “emotional distress” includes physical symptoms such as insomnia, headaches and stomach upset that can result from such emotional distress. See H. Conf. Rept. 104-737, 301 n. 56 (1996). All claims for damages resulting from physical injury or illness are deductible from income.

Even in labor disputes, some plaintiffs win in tax matters. For example, in Domeny v CommissionerMs. Domeny suffered from multiple sclerosis (“MS”). Her MS worsened due to problems at work, including an employer who embezzled money. As her symptoms worsened, her doctor determined she was too sick to work. Her employer fired her, causing her MS symptoms to further escalate. She settled her employment dispute and made some of the money tax-free. The IRS disagreed, but Ms. Domeny won in tax court. Her health and physical condition clearly worsened due to her employer’s actions, so portions of her severance pay were tax-free.

In Parkinson v CommissionerA man suffered a heart attack while at work. He reduced his hours, took sick leave, and never returned. He filed suit under the Americans with Disabilities Act (“ADA”).
”), claiming his employer failed to take into account his severe coronary artery disease. He lost his ADA case, but then filed suit in state court for willful assault and invasion of privacy.

In his lawsuit, he claimed that his employer’s misconduct caused him to suffer a heart attack that left him unable to work. He settled, claiming that a payment was tax-free. When the IRS disagreed, he went to Tax Court. He argued that the payment was for physical injuries and physical illness caused by extreme emotional stress. The IRS said it was simply taxable compensation for emotional stress. But the court said that intentionally causing emotional stress could result in physical injury.

In the end, Parkinson prevailed against the IRS. Damages for physical symptoms of emotional stress (headaches, insomnia, and stomach aches) may be taxable, but physical symptoms of emotional stress have a limit. For example, ulcers, shingles, aneurysms, and strokes can all be a result of stress. It seems difficult to consider them all as “mere symptoms of emotional stress.” Extreme emotional stress can cause a heart attack, which is not a symptom of emotional stress. The Tax Court in Parkinson agreed.

To prove a physical illness, the taxpayer must provide proof of medical treatment and proof that they actually claimed that the defendant caused or aggravated their condition. Settlement agreements should be explicit about taxes whenever possible. The tax language in a settlement agreement is not binding on the IRS. Still, you’d be surprised how often the IRS will take notice during an audit if you can show them a settlement agreement that says something explicit about taxes. Sometimes that’s enough to get them to waive taxes.

Of course, the IRS will probably consider everything as income unless you can prove otherwise. But there’s another reason to be clear so every client knows what to expect. That is, try to be clear about the tax forms in the settlement agreement as well. If you’re the plaintiff, you don’t want to be surprised by IRS Forms W-2 and 1099 arriving unexpectedly around January in the year after your case is settled. This can ruin your day and maybe even your tax return.

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