Tax Implications of Emotional Distress Settlements: A 2023 U.S. Tax Court Ruling
In the context of law, a settlement is a resolution between disputing parties about a legal case, reached either before or after court action begins. This agreement, typically in the form of a contract, is most often related to disputes involving the payment of money and serves to resolve the conflict without the need for a court trial.
Settlements can occur in a wide variety of legal contexts, from personal injury claims to complex business disputes, but they all share the same basic principle: the parties voluntarily agree to resolve the issue without proceeding further with litigation.
Taxation of settlement funds can be quite complicated, as it greatly depends on the nature of the legal claim that was the basis for the settlement. Generally, the IRS considers settlement money to be taxable income, with a few exceptions.
The general rule of thumb is that settlement proceeds from lawsuits are taxable. However, IRC section 104(a)(2) offers an exception, rendering any damages received on account of personal, physical injuries or physical sickness as non-taxable. The key for a taxpayer to fit within this exclusion is to demonstrate a direct link between the damages received and the personal injuries incurred. The nature of the claim that gave rise to the settlement is what courts primarily consider.
Consider the case of a trailblazing woman within the San Francisco Fire Department, who was amongst the few women to graduate from the Fire Academy. Unfortunately, her achievement was met with disdain by her male colleagues, leading to a hostile work environment marked by disparaging comments, equipment sabotage, and unseemly actions towards her personal belongings.
Her persistent complaints only served to intensify the harassment and soon leaked into the public sphere. In 2017, she filed a lawsuit to end the harassment, and a settlement was reached in 2018, awarding her $382,797.70, inclusive of attorney's fees. Her CPA advised her not to report this money, which led the IRS to issue a Notice of Deficiency.
The court highlighted that the settlement stated the payment would be treated as general damages for personal injury, including emotional distress, and not as back wages. The court also noted that her complaint did not allege any physical injuries, but rather focused on sex discrimination, retaliation, and emotional distress.
Despite the distress experienced, the court ruled that IRC section 104(a) explicitly states "emotional distress shall not be treated as a physical injury or physical sickness." As a result, her settlement was deemed taxable income. This case underscores the importance of understanding the tax implications of settlement proceeds and the necessity to navigate these issues correctly.
As mentioned earlier, settlement proceeds for personal physical injuries or physical sickness are usually non-taxable under IRC section 104(a)(2), provided that the damages have a direct causal link to the injuries sustained. However, other types of settlements, like those for emotional distress or defamation, are typically taxable. If a settlement is considered taxable, the recipient must report it as income on their tax return.
For more information, feel free to contact us at (207) 888-8800.
Understanding 'Reasonable Compensation' for Business Owners: A Guide for Taxpayers
The concept of "reasonable compensation is a critical aspect for business owners, particularly for those involved in both S and C corporations. Today, let's talk about the 'reasonable compensation' landscape for S corporations.
If you're a shareholder/employee of an S corporation, it could be tempting to turn wage compensation into pass-through income to lessen payroll taxes. The real challenge lies in determining – "Is the salary justifiable?" According to tax guidelines (Rev. Rul. 74-44), any distributions paid instead of fair compensation are classified as wage compensation.
The IRS insists that S corporation owners take a reasonable salary due to the way that these types of businesses are taxed. S corporations are pass-through entities, meaning their income, losses, deductions, and credits pass through to their shareholders for federal tax purposes. The shareholders report this income or loss on their personal tax returns, where it's subjected to ordinary income tax rates, but not payroll taxes (i.e., Social Security and Medicare taxes).
However, if the owner of an S corporation also performs services for the corporation (effectively acting as an employee), the IRS requires them to pay themselves a 'reasonable' salary for these services. This salary is subject to payroll taxes, just like any other employee's salary.
The rule is in place to prevent S corporation owners from avoiding payroll taxes by taking all of their income from the corporation as pass-through distribution profits, rather than as a salary. For example, without this rule, an S corporation owner could pay themselves a tiny salary (or none at all) and take the rest of their income as a distribution, thereby avoiding substantial payroll taxes.
What constitutes 'reasonable' compensation can depend on many factors such as the nature of the business, the extent of the services provided by the owner, and what similar businesses pay for those services. If the IRS determines that an S corporation owner's salary is unreasonably low compared to their distribution profits, it can reclassify some of those profits as wages, leading to back payroll taxes and penalties. Hence, it's crucial to set a salary that accurately reflects the owner's contribution to the business.
Remember, this rule applies only if you, as a shareholder, perform services for the S corporation. Non-active shareholders aren't required to draw wage compensation. Despite clear guidelines, the compliance with 'reasonable compensation' often takes a backseat, resulting in potential losses to the public treasury, as highlighted in a recent report.
It's essential for us to respect these regulations. Ignoring non-compliance can lead to hefty penalties. A fellow tax professional ended up settling a case for $34,500 due to such an oversight.
'Reasonable compensation' has implications on several aspects of your financial life:
- Payroll Taxes: If we manage to reduce your wages as a shareholder, it could decrease overall payroll tax liabilities. However, if the wages drop below a 'reasonable' level, your S corporation could face payroll tax liabilities.
- §199A Deduction: Overpaying wages might shrink the corporation’s qualified business income (QBI), potentially reducing your §199A deduction. But, in certain scenarios, an increase in wages could expand the §199A deduction.
- Social Security Benefits: Regularly low wages might impact your retirement benefits, especially if the S corporation is your sole income source.
- State Taxes: Paying too much in wages might reduce the income eligible for the state-level pass-through elective entity tax.
- Retirement Contributions: If your maximum annual retirement contribution is linked to wage compensation, low wages could restrict your ability to defer income.
- SECURE 2.0 Rule: According to SECURE Act 2.0 of 2022, overpaying your wages as a shareholder could affect your retirement contributions.
If the IRS determines that an S Corporation owner's salary is unreasonably low, they can reclassify some or all of the owner's distributions as wages. The consequences can be quite serious. The corporation could be required to pay unpaid payroll taxes, plus interest, and potentially face penalties. These assessments can be applied retroactively, leading to significant unexpected costs.
Furthermore, underpayment of salary can also have impacts on the owner's personal financial situation. For example, it can limit the amount the owner can contribute to a retirement plan, which is often based on their salary. It could also reduce the amount of Social Security benefits the owner is eligible for upon retirement, as these benefits are calculated based on your earnings history.
Therefore, it's very important for S Corporation owners to ensure they are taking a reasonable salary for their role and responsibilities, both to comply with IRS rules and to protect their own financial future.
New Scam Targets Unclaimed Tax Refunds, Warns IRS
The Internal Revenue Service (IRS), alongside its Security Summit partners, has issued a warning regarding a novel scam. Fraudsters are reportedly sending cardboard envelopes, posing as a delivery service, urging recipients to share photographs and banking details to claim a supposedly unclaimed tax refund.
The scam letter, featuring the IRS logo, asserts it's related to an "unclaimed refund." However, the contact details and phone number provided do not belong to the IRS. The fraudsters request sensitive personal information, including detailed images of driver's licenses, thereby exposing taxpayers to potential identity theft.
IRS Commissioner Danny Werfel stated, "These identity thieves masquerade as the IRS, hoping to deceive individuals into surrendering valuable personal information. This allows them to steal identities, money, and tax refunds. Such scams can appear as emails, texts, or special mailings, so people should be vigilant about such red flags."
The Security Summit, a collaborative effort between the IRS, state tax administrators, and the tax preparation industry, advises the public to safeguard their personal information against such scams and potential tax-related identity theft.
The new scam is characterized by similar features found in fraudulent emails and text messages. Its distinct aspect lies in attempting to coax individuals into sharing their personal information over phone calls or emails.
The fraudulent letter specifies the need to provide "Filing Information" to claim the refund. It includes poorly worded requests, such as a clear photograph of the recipient's driver's license, taken from all four angles in well-lit conditions.
Further sensitive information is solicited, including mobile phone numbers, bank routing details, Social Security numbers, and bank account types. The letter concludes with a strangely worded warning.
The scam letter exhibits several red flags, including unusual punctuation, font inconsistencies, and factual inaccuracies. For instance, it misstates the deadline for tax refund filings as Oct. 17, even though the deadline for extended 2022 tax returns is Oct. 16. The letter erroneously references "unclaimed property," which the IRS does not handle.
For more information or for help reporting a scam, please contact Heritage Tax Company at (207) 888-8800.