By: Dan Finn, CPCU, MSSC, RICP ®
Abstract: Structured settlements for non-physical injury disputes, such as those arising from wrongful termination and similar employment-related lawsuits, remain a surprisingly underused and unappreciated settlement resolution tool. By taking the time to understand how this useful strategy can positively impact settlement talks, mediators will be better positioned to demonstrate how a series of tax-deferred cash flows can help level out the plaintiff’s tax burden leading to a better, fairer outcome for all parties.
Wrongful termination and similar employment lawsuits present litigants, their counsel and mediators with a few challenges not encountered during negotiations involving most other types of personal injury claims.
One of those challenges is taxes. Unreasonable taxes. Unfair taxes.
Unlike plaintiffs who compromise their physical injury disputes and pay zero taxes on their settlement proceeds (exclusive of punitive damages), those who choose to resolve their employment differences for a single lump sum can end up relinquishing an excessive share of their recovery to taxes.
Regrettably, this grim reality isn’t often realized until well after the case has resolved. Even more regrettable is the fact that overpaying taxes on employment settlements is completely avoidable.
Mediators who are conscious of these dual realities and understand how easily they can help parties overcome them stand to distinguish themselves as conscientious conflict arbitrators who can bring about the fairest of all possible outcomes.
Physical Versus Non-Physical Injury Claims
26 U.S. Code § 104(a)(2) exempts from taxation any damages (other than punitive) whether paid as a lump sum or as periodic payments received “on account of personal physical injuries or physical sickness” even though the word “physical” remains undefined.
Prior to 1996, however, the word “physical” had yet to be added to the code leaving the tax treatment for many types of claims open to interpretation. For obvious reasons, practitioners sought to qualify all sorts of damages, emotional distress chief among them, under § 104(a)(2) in their complaints even when the origin or fact pattern of the claim strayed from the original intent of the law.
Several court cases later (primarily United States v. Burke, Commissioner v. Schleier and Murphy v. IRS), prompted legislatures to address this tax ambiguity culminating with the Small Business Jobs Protection Act of 1996 (Public Law 104-188). The new law added the word “physical” to the code and clarified that emotional distress, unless stemming from an underlying physical injury, was indeed taxable. (See § 1605(b) of P.L. 104-188)
Taxable cash awards, particularly large ones, create serious tax inequity by catapulting the plaintiff into an extraordinarily high tax bracket for a single year even though the award may have been intended to compensation the aggrieved party for years into the future, even a lifetime.
Where is the equity in this?
Clarity Creates Opportunity
With the door for preferential tax treatment of damages permanently closed for wrongful termination and similar torts, the structured settlements industry stepped in to solve the fairness imbalance created when plaintiffs are forced to accept their settlement or verdict in a single lump sum.
By modifying the Qualified Assignment process used to facilitate physical injury structured settlements which pay future income that is 100% income tax-free, the industry was able to create an alternative which allows plaintiffs involved in nonphysical injury claims to mitigate their tax liability.
A Non-Qualified Assignment process now exists which helps parties arrange to have their settlement dollars – and their tax liability – spread out over time. A favorable 2008 Private Letter ruling from the Department of the Treasury (PLR 200836019) reinforced this settlement alternative as a sensible money saving tax deferral strategy.
Save Money, Save Face
Plaintiff A is a single taxpayer earning $80,000 a year (23% tax bracket) after being fired from his job. He plans to work another 15 years but $80,000 is about half of what he had been accustomed to earning. He resolves his wrongful termination lawsuit and nets $1,000,000 which he opts to take in cash.
Using current tax rates for a California taxpayer, Plaintiff A will pay roughly $467,000 in taxes on his $1,000,000 recovery.
Plaintiff B, on the other hand, is also a single taxpayer in identical circumstances and resolves an identical lawsuit netting her $1,000,000. However, she chooses to have her recovery spread out over the next 15 years to avoid the unreasonable, one-time, 47% tax burden. Instead, she chooses to have it paid out over time via a Non-Physical Injury Structured Settlement which lowers the tax she pays on her $1,000,000 to $396,400 – a 15% reduction – netting her $70,600 MORE than if she had chosen the cash lump sum. All at no out-of-pocket cost to anyone.
Aside from the immediate tax savings, the best part about Plaintiff B’s settlement is that it returns her to her pre-termination cash flow situation. The structured settlement generates roughly $80,000 a year for the next 15 years which, when coupled with her current salary, brings her back to $160,000 of taxable income she had been accustomed to. All on a tax advantaged basis.
All Sides Benefit
Cash offers and demands limit the parties during taxable damage negotiations and can lead to impasse. Employing a Non-Physical Injury Structured Settlement strategy instead affords both sides a better opportunity to bridge the negotiation gap more effectively by focusing on the plaintiff’s after-tax income rather than the gross value of the settlement. Mediators who embrace this creative, needs-based approach to negotiations validate their reputations as fair-minded arbiters who could very likely see their practices enhanced as a result.