Tax Cuts and Jobs Act of 2017First, let’s explain what the new tax reform is and why it was created. The Tax Cuts and Jobs Act of 2017 is a congressional revenue act amending the Internal Revenue Code of 1986, and regardless if you are a plaintiff or an attorney, the new tax reform will impact your life. Major elements of the changes include:
- reducing tax rates for businesses and individuals
- a personal tax simplification by increasing the standard deduction and family tax credits
- eliminating personal exemptions and making it less beneficial to itemize deductions
- limiting deductions for state and local income taxes (SALT) and property taxes
- further limiting the mortgage interest deduction
- reducing the alternative minimum tax for individuals and completely eliminating it for corporations
- reducing the number of estates impacted by the estate tax
- repealing the individual mandate of the Affordable Care Act
Impact on Plaintiffs and AttorneysPresident Trump’s tax changes have altered prior tax law regarding the handling of personal injury settlements. Unfortunately, the new legislation includes a provision that will disallow deductions for defendants with regards to settlements or payments relating to or allocated to sexual harassment claims. According to section 162(q), no deduction is allowed for:
“(1) any settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement, or (2) attorney’s fees related to such a settlement or payment.”
Because this is written in such vague language, one could argue that not only can defendant employers not deduct payments made to own counsel to defend such claims but plaintiffs cannot deduct attorney fees related to the claim. Until now, compensatory damages have been completely tax free while punitive damages were subject to tax rates. The new tax reform allows only compensatory damages that involve physical damage or injuries to be treated as tax free income. What remains unclear is what happens when physical injuries lead to emotional distress.
While the answer to that question remains to be seen, what we do know is that punitive damages and interest are taxable. So, if a claim is made for emotional distress, damages are taxable. But again, what if your emotional distress causes so much stress that it leads to a physical sickness? Supposedly, your damages are taxable. On the contrary, if a physical sickness and/or physical injury leads to emotional distress, those damages should remain tax free. Sound pretty straight forward? Nope. You are probably just as confused as the rest of us. Let’s take a look at real world examples.
Case that is Fully Non-taxable
Let’s say a plaintiff is involved in an auto accident and is physically injured and receives compensatory damages. There should be no tax issues as physical damages are not taxable.
Case that is Fully Taxable
Let’s say a plaintiff is involved in a suit for intentional infliction of emotional distress that settles for $50,000 with a 30% contingency fee for the attorney. The plaintiff will receive a check for $35,000 (70% of $50,000), but be taxed on the full $50,000. In years past, the plaintiff would be able to claim a $15,000 miscellaneous itemized tax deduction for those legal fees.