Myth #2: What have taxes got to do with it?

Litigator Natalie Brandt explores the myths we believe about our legal system

By Natalie Moore Brandt

Editor’s note: This is the second in a series about the myths people believe about our legal system that litigator Natalie Moore Brandt has witnessed in her career. You can find Myth #1 here.

 

Myth #2: What have taxes got to do with it?

A lot! Money awarded in a settlement as a result of litigation is not “free” money. Whether you settle out of court or win at trial, the IRS has a lot to say about how parties account for the money.

At trial, parties are at the mercy of the judge or jury, so tax implications are relevant after-the-fact as to how one accounts for the dollars in or dollars out. Were you awarded punitive damages or was interest assessed on an unpaid debt? Prepare to pay taxes on both. But most cases settle out of court – which is certainly true for my practice – so tax implications should be considered when negotiating. That may seem like an obvious statement, but I’ve found that folks are frequently surprised to learn that settlements are taxable events (but for very few exceptions like personal injury cases, which must be a physical injury). Defense clients are just as often surprised to learn that some settlements are tax deductible, as the cost of litigation can be a business expense. While it’s not always practical to have a tax expert on speed dial or in attendance at mediation, being mindful of the role the IRS plays in litigation can and should inform how parties reach a resolution. Either way, it all depends on the nature of the underlying case.

For instance, if an employee sues for and recovers her unpaid wages, her settlement is going to be taxable as income. One, her settlement money is unpaid wages. Two, wages are taxable income. This is a very simple example, but it is illustrative of just how the nature of the lawsuit will dictate the tax, if any, at issue. And during settlement negotiations, it’s good for clients to know whether to expect a tax bill, or on the flip side, a hefty deduction, which can soften the sting of any check they’re about to write. After all, busting the myth that taxes do play a role in litigation can have its upside.