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Settlement And Taxes: Must I Pay For Dancing

by Phyllis Pollack
December 2008

From the Blog of Phyllis G. Pollack.

Phyllis  Pollack

       To prepare for mediation, many parties review the strengths and weaknesses of their cases, the costs to prosecute or defend a dispute in relation to amounts they are willing to pay or accept in settlement, and otherwise their Best Alternatives To A Negotiated Agreement or BATNA.

       But how many think about taxes?

       Last week, I mediated a breach of contract matter in which the plaintiff was concerned that any settlement amount he accepted would be taxable income. Evidently, he had checked with his accountant prior to the mediation on this issue and received this advice. In light of it, he wanted to structure the settlement to minimize his tax liability.

       Although I was acquainted with the issue, as a neutral, I was uncomfortable espousing any opinion about it. Taxes are complicated to begin with and so, as a neutral, who had only a limited amount of knowledge about this dispute and the parties to begin with,  I was not about to give legal advice. Like any good neutral, I demurred to his tax advisor.

      But the issue is one not to be ignored. So, given the accessibility of information courtesy of the worldwide web, I went on to the internet to find out what the IRS has to say on this topic. Sure enough, in its Publication 525 (2007), it sets out what is and what is not taxable income. On page 29, it states in full:

      “Court awards and damages. To determine if settlement amounts you receive by compromise or judgment must be included in your income, you must consider the item that the settlement replaces. The character of the income as ordinary income or capital gain depends on the nature of the underlying claim. Include the following as ordinary income.

      1. Interest on any award.

      2. Compensation for lost wages or lost profits in most cases.

     3. Punitive damages, in most cases. It does not matter if they relate to  a physical injury or physical sickness.

     4. Amounts received in settlement of pension rights (if you did not contribute to the plan).

     5. Damages for:
            a. Patent or copyright infringement,
            b. Breach of contract, or
            c. Interference with business operations.

     6. Back pay and damages for emotional distress received to satisfy a claim under Title VII of the Civil Rights Act of 1964.

     7. Attorney fees and costs (including contingent fees) where the underlying recovery is included in gross income. 

      Do not include in your income compensatory damages for personal physical injury or physical sickness (whether received in a lump sum or installments).”


        Thus, it seems that unless the settlement sums represent compensation for personal injury or physical sickness (26 U.S.C. §104(a)(2)), any sums received in settlement may very well constitute taxable income.

       As I said, I am not and never was a tax attorney. I make all disclaimers here and now to the effect that this blog constitutes tax advice: it does not. It simply raises an issue: are those long sought after and hard fought for settlement sums taxable? If so, should the settlement be structured to minimize the potential tax liability? To answer these questions, I strongly  urge you to consult a tax attorney, a CPA, an accountant or someone extremely knowledgeable (if not licensed and certified) in this area. I also strongly urge you to do this prior to the mediation. Otherwise, the rewards you reap from resolving your dispute may not end up in your pocket but rather in the IRS’ aka the U.S. Treasury.

       . . . Just something to think about.


Phyllis Pollack with PGP Mediation uses a facilitative, interest-based approach. Her preferred mediation style is facilitative in the belief that the best and most durable resolutions are those achieved by the parties themselves. The parties generally know the business issues and priorities, personalities and obstacles to a successful resolution as well as their own needs better than any mediator or arbitrator. She does not impose her views or make decisions for the parties. Rather, Phyllis assists the parties in creating options that meet the needs and desires of both sides.  When appropriate, visual aids are used in preparing discussions and illustrating possible solutions. On the other hand, she is not averse to being proactive and offering a generous dose of reality, particularly when the process may have stalled due to unrealistic expectations of attorney or client, a failure to focus on needs rather than demands, or when one or more parties need to be reminded of the potential consequences of their failure to reach an agreement.

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