Recent U.S. Tax Court Opinion Illustrates How Language in Settlement Agreements Can Determine Tax Treatment of Payments

In Mennemeyer v. Commissioner,¹ the United States Tax Court reminds us that a settlement agreement that is not carefully drafted can have significant tax consequences. 

Background 

The employee was employed as a financial specialist. She was fired for dishonesty, which made it difficult for her to find subsequent work. She initiated Financial Industry Regulatory Authority (FINRA) arbitration, asserting claims for defamation, wrongful termination, unfair competition, tortious interference with business expectancy, and expungement. The employee was awarded $300,000 in compensatory damages and $1,500,000 in punitive damages. After the employer filed a Petition to Vacate Arbitration Award, petitioner and the employer reached a settlement agreement in which the employer agreed to pay the employee $1,510,000 in two installments – $997,466 was to be paid to the employee and $512,534 to her attorneys. The agreement also included a general release of claims related to petitioner’s employment and/or termination. 

Following her tax attorney’s advice, the employee reported $498,733 of the settlement in her 2018 income tax return as taxable income. In 2023, the IRS issued a Notice of Deficiency determining a deficiency of $588,906, in large part, due to the settlement award the employee received from her employer. The tax court was tasked with resolving several issues, among them whether petitioner had unreported income from the arbitration agreement and whether attorneys’ fees were deductible. 

The Tax Court’s Analysis

The tax court first addressed whether any of the award was tax exempt as a “personal physical injury” within the meaning of IRC section 104(a)(2). The employee argued that her settlement was related to health concerns she claims began during her employment. To support her contention, the employee produced witness testimony regarding her health condition during her employment, but did not provide any medical records. Finding that most of the testimony lacked credibility, the tax court rejected the employee’s argument, stating that the settlement agreement expressly released claims related to the employee’s “employment and/or termination of employment” with her employer, and made no mention of personal injuries. Even if the settlement agreement was ambiguous, the surrounding circumstances support the conclusion that the purpose of the settlement was to resolve defamation and related economic claims. Thus, the tax court sustained the commissioner’s deficiency determination finding that no portion of the settlement was for a tax-exempt personal physical injury. 

As for the attorney’s fees, the tax court considered petitioner’s argument that such fees are deductible under IRC section 62(a)(20), which permits above-the-line deductions “for attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination.” Section 62(e) defines unlawful discrimination as unlawful acts under federal, state or local law that “regulat[es] any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.” The tax court concluded that petitioner’s claims were related to her employment relationship and lost wages, thus fitting within the definition prescribed by section 62(e). 

Takeaways

Failure to draft settlement agreements carefully can lead to unintended tax issues for the parties and their attorneys. Although Mennemeyer involves an employee’s failure to report income to the IRS, it offers the following reminders to employers: 

• Parties should ensure that the settlement agreement includes express language specifying the purposes of any compensation with the specificity needed to support a particular tax treatment;
• While intent of the payor will be considered when courts are faced with an ambiguous agreement, parties should not assume their intent will be supported by surrounding facts and circumstances;
• Agreements should clearly state how the proceeds are to be allocated (e.g., award for defamation and attorney’s fees); and
• Since a settlement award for defamation is taxable income although not wages, employers must report such payments as income on an IRS Form 1099-MISC.  

Parties should carefully consider the above points to avoid unintended consequences. The use of recitals can be an effective way to set out both the payor’s intent and the reasons for the allocations and purposes of settlement so that resort to other evidence will not usually be required. As always, you can consult your employment tax counsel for further assistance.