The IRS’ Lawsuits, Awards, and Settlements Audit Techniques Guide

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The IRS’ Lawsuits, Awards, and Settlements Audit Techniques Guide

Some time ago, the IRS issued an Audit Techniques Guide on the taxation of lawsuits, awards, and settlements.  As many tax practitioners can attest, there are a multitude of tax issues involving any one of these issues.  In any event, and although the Audit Technique Guide (“Audit Guide”) is somewhat dated, it is still worth a read to get a quick review of the issues an IRS auditor will focus on when these types of issues have been identified in an IRS examination.


Section 104(a)(2) of the Code provides the tax treatment rules for amounts received “on account of personal physical injuries or physical sickness.”  Generally, if a lawsuit or settlement amount fits within Section 104(a)(2), the payment is not taxable.  However, the Audit Guide cautions IRS examiners that Section 104(a)(2) only applies to individuals because federal courts have concluded that a business entity cannot suffer a personal injury within the meaning of Section 104(a)(2).

The Introduction of the Audit Guide also discusses the amendments to Section 104(a)(2), which were made in 1996. Significantly, the amendment clarified that emotional distress damages or settlement payments should not be treated as physical injury or physical sickness (i.e., they should be taxable) except to the extent such amounts are paid for medical care attributable to emotional distress.  For these purposes, the Congressional report accompanying Section 104(a)(2) provided that emotional distress includes physical symptoms, such as insomnia, headaches, and stomach disorders, which may result from emotional distress.

The amendment to Section 104(a)(2) also clarified that punitive damages are not excludible under Section 104(a)(2), regardless of whether they are received in connection with physical or non-physical injury.

IRS Audit Issues

The Audit Guide instructs IRS auditors to look at various issues when reviewing IRS tax audits involving issues of lawsuit verdicts and settlements.  Generally, many of the issues identified in the IRS Audit Guide are designed to tease out whether the payment has been properly treated for federal tax purposes.  These issues include:

  • Whether any lawsuit, award, or settlement payment has been unreported;
  • Whether payments have been properly allocated among taxable and non-taxable amounts;
  • Whether any part of the payment should be treated as punitive damages (e., taxable);
  • Whether any part of the payment should be treated as interest (e., ordinary income); and
  • Whether the taxpayer has reported the amounts received as gross rather than reporting them net of legal and other fees (important now that federal tax law generally disallows attorneys’ fees characterized as miscellaneous itemized deductions).

Taxability of Lawsuit Payments

Generally, federal tax law provides that the term “gross income” should be interpreted broadly.  However, because Section 104(a)(2) excludes certain income from the definition of “gross income,” taxpayers generally must show that the payments fit neatly within the exception.  If the taxpayer fails to make this showing, the taxpayer will be required to report the income for federal income tax purposes.

Difference Between Jury/Court Verdicts and Out-of-Court Settlements

Generally, a taxpayer may receive a payment from either a jury/court verdict or an out-of-court settlement.  The distinction sometimes matters for federal income tax purposes.

For example, if a taxpayer’s damages have been clearly allocated to an identifiable claim in an adversarial proceeding with a judge or jury, the IRS will generally not challenge the character of the payment because of the impartial and objective nature of the determinations.

However, where there is a settlement out of court, taxpayers have more ability to try to characterize the payment in a tax favorable manner.  Accordingly, the Audit Guide instructs IRS examiners to “closely review[ ]” such settlements to determine whether the treatment and allocations are proper and reflect the economic substance of the settlement.

Physical Injury or Sickness.

 The IRS has consistently held that compensatory damages, even for lost wages, received on account of personal physical injuries are excludable from gross income (with the exception of punitive damages).  Rev. Rul. 85-97.  Even after amendment to Section 104(a)(2), the House Committee Report stated:

If an action has its origin in a physical injury or physical sickness, then all damages (other than punitive) that flow therefrom are treated as payments received on account of physical injury or physical sickness whether or not the recipient of the damages is the injured party.   

Emotional Damages

Notably, however, emotional damages are not excludible under Section 104(a)(2).  For example, the Tax Court has held that a tort recovery for various claims, including emotional distress, was not excludible under Section 104(a)(2) because the recovery was not received on account of personal physical injuries or physical sickness.  See Emerson v. Comm’r, T.C. Memo. 2003-82.  Moreover, the Tax Court has held that a tort recovery for various claims, including emotional distress and defamation, was not excludible because it was not received on account of personal physical injuries or physical sickness.

Punitive Damages

As discussed above, punitive damages are not excludible under Section 104(a)(2).  Because taxpayers in out-of-court settlements have a natural tendency to want to characterize settlement payments as not constituting payments for punitive damages, the Audit Guide cautiones auditors to look closely to the settlement agreement to determine whether any settlement payment (or part thereof) should be characterized as punitive damages.  According to the IRS, if some of the payment does constitute punitive damages, “[a] reallocation may be needed.”

Product Liability

There are many cases which involve claims of damages related to product liability.  The Audit Guide cautions IRS auditors that “[t]hese types of cases will usually involve the various elements relative to compensatory damages for physical and mental injury[.]”  Thus, “[p]roper allocations among the taxable and nontaxable portions received must be determined.”

Employment-Related Claims.

Employment-related lawsuits may arise in a variety of different contexts, all of which are instructive in how to properly treat the payments for federal tax purposes.  If the damages received are designed to compensate economic loss—lost wages, business income, and benefits—such payments are not excludible from gross income unless the result of a physical injury.

Discrimination Suits

Federal statutes provide causes of action for discrimination.  These claims may include discrimination on the basis of age, race, gender, religion or disability.  Generally, these types of cases generate compensatory, contractual and punitive awards, none of which are excludible under Section 104(a)(2).

Defamation and Libel

Generally, defamation and libel awards or settlement payments are designed to compensate the plaintiff for damages to reputation.  The IRS tends to view these types of awards or payments—whether business or personal—as a non-physical injury and therefore taxable.  However, federal courts have disagreed with the IRS’ position, particularly in years prior to amendment of Section 104(a)(2).

Payroll and Self-Employment

Not surprisingly, an award or settlement payment can also constitute a payment subject to payroll or self-employment tax.  Generally, this may be the case if the award or settlement payment would have been subject to these taxes in the first instance—e.g., back wages.  See, e.g., Rev. Rul 96-65; Social Security Board v. Nierotko, 327 U.S. 358 (1946) (back pay award to illegally terminated employee under FLSA held to be wages for social security benefit purposes).

Recognizing this, the Audit Guide reminds IRS auditors that the definition of “wages” for purposes of payroll and income tax withholding is broad.  Thus, IRS auditors are advised that the label placed on settlement payments should not govern whether the payments are subject to payroll and other withholding obligations.

Gross Income Amount

Generally, plaintiffs prefer to report the net of their recovery as gross income.  For example, plaintiffs prefer not to have to report the total gross income with deductions for attorneys’ fees.  At one point in time, this was because attorneys’ fees could be deducted as miscellaneous itemized deductions subject to AMT.  However, at the current time, plaintiffs are generally prohibited from claiming any attorneys’ fees deduction at all if they are an individual and are attempting to claim a miscellaneous itemized deduction.  This is because miscellaneous itemized deductions have currently been phased out.

In Comm’r v. Banks, 543 U.S. 426 (2006), the Supreme Court held in favor of the IRS that gross income includes not only the recovery but also the amount of contingent attorneys’ fees.

Above-the-Line Deduction for Attorneys’ Fees

In some cases, plaintiffs may claim attorneys’ fees above-the-line under Section 62(a)(20).  Generally, these cases involve “unlawful discrimination,” certain claims against the federal government, and a private cause of action under the Medicare Secondary Payer statute.  The amount of the deduction is limited to the amount includible in the plaintiffs’ gross income for the tax year in which the deduction is being claimed.

Legal Fees for Non-Taxable Awards and Settlements

No legal fee deduction is permitted for legal fees allocable to non-taxable awards or settlements.  Absent strong support to the contrary, legal fees relating to an award or settlement payment that is taxable and non-taxable will be allocated based on the ratio between the taxable award/settlement and the total award/settlement.  See Johnson-Waters v. Comm’r, T.C. Memo. 1993-333; Church v. Comm’r, 80 T.C. 1104, 1110 (1983).


In some causes of action, a plaintiff may be entitled to interest as part of an award.  Interest associated with an award or settlement is always taxable.  Aames v. Comm’r, 94 T.C. 189 (1990); Kovacs v. Comm’r, 100 T.C. 124 (1993).

IRS Examination Considerations

Generally, the IRS will discover a lawsuit award or settlement through either an issued Form 1099 (by the defendant) or while performing a bank deposit analysis.  In these cases, IRS auditors are instructed to develop the facts.  In most cases, this involves interviews with the taxpayer and also requests for documents.


Under IRS guidance, IRS auditors are responsible for considering the application of penalties in all cases under examination.  If a return has not been filed and the taxpayer has received an award or settlement payment, the IRS auditor is instructed to consider:  (1) the failure to pay penalty; (2) the failure to pay penalty; (3) estimated tax penalty; and (4) fraudulent failure to file penalty.  In determining whether penalties are appropriate, the IRS examiner is instructed to:  (1) consider whether the taxpayer fully disclosed all pertinent facts to his or her attorney; (2) the advice received by the attorney regarding the taxability of the settlement amount; and (3) whether the taxpayer should have questioned the advice of his or her attorney regarding the taxability of the payment.

Information Returns

In many cases, an information return will be filed by the defendant in the action.  These information returns can be significant for purposes of determining the characterization of a settlement payment.  Moreover, these information returns are sometimes subject to negotiation amongst the parties.  These information returns may include Forms 1099 and W-2.


The taxation of settlement payments and awards is a complex matter.  Generally, it is advisable to consult with a knowledgeable tax advisor while a lawsuit is ongoing and especially prior to executing a settlement agreement so as to better position the plaintiff for the characterization of the settlement payment or award.  In cases in which a plaintiff engages a tax attorney, the plaintiff may be expected to keep more of their recovery through proper tax planning.

A copy of the IRS Audit Guide discussed in this Insight may be found here.