Tax Mistakes Attorneys Make When Negotiating Settlements

Tax expert Robert W. Wood, author of Taxation of Damage Awards and Settlement Payments among other treatises and an attorney with San Francisco’s Wood & Porter, answered questions about how lawyers can avoid tax mistakes during settlement negotiations. Following is brief snippet of an interview that ran in our Summer issue of the Dispute Resolution Alert newsletter.

Q.  What are typical tax-related mistakes that attorneys make when negotiating settlements? 

A.  The three biggest mistakes are not considering taxes early enough in settlement negotiations, not having a clear tax plan of what their client wants and what support they can show the other side to get what they want, and not having a tax adviser waiting in the wings to vet language and break a logjam if one develops.

Q.  What are the primary tax considerations for plaintiffs in settlement negotiations?

A.  Understandably, plaintiffs want to maximize their take home.  After attorneys’ fees and costs, they may have a good sense what the remaining cash will be.  But taxes are another matter.  They want a tax computation, which can be counterintuitive.  For example, although a client may be entitled to 60 percent of the net proceeds, if the lawyer receives 40 percent, the tax law generally treats the client as receiving 100 percent, even if the plaintiff's lawyer is paid directly and separately by the defendant.  Many plaintiffs cannot deduct some or all of the legal fees, so they may receive 60 percent of the settlement monies, but paying tax on 70 percent, 80 percent or more.  Tax-deduction rules, especially under the Alternative Minimum Tax, are very complex.

Q.  What are the primary tax considerations for defendants?

A.  Defendants want to obey tax laws and not cause themselves any liability or scrutiny from a tax or financial statement point of view based on how they treat settlement dollars.  Defendants want the case resolved, but they don’t want to compromise their tax or reporting duties, or to mischaracterize the settlement.

Q.  What kinds of disputes tend to have the most tax consequences during settlement?

A.  Employment.  They aren’t the most complicated disputes, but they inevitably have tax components.  There will almost always be a wage component, which requires withholding of income and employment taxes.  Many plaintiffs fight this.  An even bigger dispute may erupt over whether any portion of the settlement can be excluded from the plaintiff’s income as nontaxable damages for personal physical injuries or sickness.

To read the rest of the interview with Robert Wood and learn more about avoiding tax mistakes, please click here.