Employment litigation, like most litigation, is fast-moving. Given that the overwhelming majority of cases settle out of court, it is often necessary for plaintiff and defense counsel to negotiate and execute comprehensive settlement agreements in a hurry. The various possible post-settlement tax implications to the client will likely not loom large in the litigator’s mind.

This oversight, while perhaps understandable, can lead to the undertaking of costly risks by both parties, albeit for different reasons. And because settlement agreements, once executed, are unlikely to be amended (particularly if that requires continued cooperation of the parties), it is probably unreasonable to assume that an oversight can be easily corrected after the fact.

Accordingly, it is useful for litigators otherwise unconcerned by their clients’ tax-planning needs to remember a few short but highly relevant rules potentially applicable to their pending settlements and to consider whether and how the specific language in a settlement agreement may affect a client involved in an employment-based lawsuit. The section references that follow are to the Internal Revenue Code of 1986, as amended.

• Rule 1: Settlement payments to plaintiffs in employment-based litigation are generally taxable.

Because the gravamen of an employment-based lawsuit usually involves claims for unpaid compensation (e.g., back pay), settlement of such litigation generally results in payments that are fully taxable to the plaintiff, notwithstanding frequent attempts to fit such payments within the scope of Section 104(a)(2). That section exempts from federal income taxation all amounts received as damages (other than punitive damages) “on account of personal physical injuries or physical sickness.”

In 1996, the Small Business Job Protection Act amended Section 104(a)(2) to provide that only damages attributable to personal physical injuries would be excludible from gross income. It also added to Section 104(a) a sentence providing that “for purposes of paragraph (2), emotional distress shall not be treated as a physical injury or physical sickness.” The legislative history elaborates on the intended impact of this sentence as follows: “Thus, the exclusion from gross income does not apply to any damages received … based on a claim of employment discrimination or injury to reputation accompanied by a claim of emotional distress.” This language makes clear that, in order for an emotional distress claim to result in damages that are exempt from taxation under Section 104(a)(2), it is necessary for such a claim to originate in a tort action based on personal and physical injury.

• Rule 2: Even if taxable, settlement proceeds may or may not constitute “wages.”

In the employment litigation context, if Section 104(a)(2) does not apply to exempt settlement proceeds from taxation, a portion of such proceeds will almost certainly be treated as “wages” for federal income tax purposes. Categorization of such proceeds as wages will likely be of great significance to both parties, since wages are generally subject to (1) income tax withholding by the employer-payor, and (2) FICA and FUTA tax liability, imposed on both employer and employee.

Accordingly, lawyers settling employment-based lawsuits are generally well-advised to prepare the settlement agreement with an explicit allocation of the payments between (1) taxable wages, which are reported on Form W-2 and are subject to federal and state income and payroll tax withholding, and (2) taxable nonwage recoveries, which are not subject to withholding and are typically reported on Form 1099. For example, a settlement agreement in a discrimination-based lawsuit that recites a valid claim for damages based on emotional distress should identify settlement proceeds that are attributable to such a claim, so that the defendant employer is not required to withhold income or payroll taxes from the settlement payment.

Note that an allocation of settlement payments between various categories of claims and damages will not necessarily be respected by either the IRS or a court. Plaintiffs looking to implement such an allocation should be prepared to defend and support the numbers on the basis of the underlying facts and circumstances.

Rule 3: Payment of plaintiff’s legal fees results in taxable income to plaintiff.

The federal income tax rules applicable to the defendant’s payment of the plaintiff’s legal fees led to near-intractable confusion for many years. Happily, the Internal Revenue Code was amended in 2004 to eliminate much of the ambiguity previously surrounding this area, at least in the employment litigation context.

The threshold question is whether the plaintiff’s attorney fees, when paid by the defendant, constitute taxable income to the plaintiff. In Commissioner v. Banks , the U.S. Supreme Court resolved a conflict among the federal circuits and held that a taxpayer must include in income the entire amount of a judgment or settlement, including the portion paid to his attorney as a contingent fee. Prior to the American Jobs Creation Act of 2004, however, certain restrictions imposed on the deductibility of “miscellaneous itemized expenses” meant that inclusion of attorney fees in the plaintiff’s gross income was problematic, because of the likelihood that he would not be able to fully neutralize such income inclusion with an equal and offsetting tax deduction.

The 2004 act amended Section 62(a)(20) to provide that, in calculating taxpayers’ “adjusted gross income,” a full deduction (an “above-the-line” deduction) is now available for attorney fees paid “in connection with any action involving a claim of unlawful discrimination.” The term “unlawful discrimination” is defined in Section 62(e) as an action that is unlawful under any of a laundry list of federal anti-discrimination and whistleblower protection statutes. Thus, the amendment clarifies that attorney fees includible in a plaintiff’s gross income may now be eligible for an equal and offsetting deduction, thereby resulting in a net wash to the plaintiff.

While there does not appear to be authority directly on point, it is generally thought that attorney fees paid on the plaintiff’s behalf, while includible in plaintiff’s gross income, do not constitute wages for federal income tax purposes and therefore do not require income or payroll tax withholding.

• Rule 4: Most settlement payments, including attorney fees, require tax reporting.

As noted above, settlement payments directly received by a plaintiff in the context of employment-based litigation will be subject to a number of tax reporting requirements, assuming such payments are not altogether exempted from taxation under Section 104(a)(2), as to which no reporting is required. For example, the employer-payer will generally report such payments to the IRS, either on Form W-2 (if the settlement payment constitutes “wages” for tax purposes) or Form 1099 (if the payment includes nonwage items such as emotional distress injuries or attorney fees).

However, where settlement payments are made directly to the plaintiff’s counsel — for example, a gross check remitted to counsel’s trust account, out of which the attorney collects his fee and remits a net check to the plaintiff — the payer has an obligation to report such payment to the attorney. Under Section 6045(f), every person making a payment, in the course of his trade or business, to an attorney “in connection with legal services” must report the payment on Form 1099, regardless of whether the payment constitutes income to the attorney or whether the services are performed for the payer. In this context, such reporting obligation will frequently lead to duplicate reporting, in an aggregate amount that exceeds the total settlement amount. Thus, a defendant remitting a gross check to plaintiff’s counsel — intended to cover the settlement payments to the plaintiff as well as plaintiff’s legal fees — will be required to report the entire amount on Form 1099, in addition to reporting separately the portion of such payment that is treated as wages and/or nonwage taxable income to the plaintiff, on Forms W-2 and 1099, respectively.

As the foregoing suggests, tax issues clearly matter in settling litigation, perhaps nowhere more so than in employment-based litigation, and litigators ignore them at their and their clients’ peril. Counsel should bear this in mind as litigation wends its way through the settlement process and would be well-advised to consult a checklist addressing the following issues:

• Is all or any portion of the proposed settlement taxable compensation income to the plaintiff? If so, clearly identify in the settlement document those portions of the payment that are subject to income and payroll tax withholding, and those portions that may be paid without withholding.

• Prepare the settlement agreement with an eye toward formulating a consensus among plaintiff and defense counsel as to the tax treatment applicable to the settlement payment and the appropriate reporting of it.

• Depending on the specific mechanism used to effect payment of the settlement amount, be prepared to report each element thereof in respect of the recipient party, including the plaintiff’s attorneys.

This article first appeared in the New Jersey Law Journal , a Legal affiliate.

RICHARD D. MARTINSON is counsel to the tax and corporate groups of.Riker Danzig Scherer Hyland & Perretti in Morristown, N.J.