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Violation, Humiliation, Litigation and Taxation

Erin_Andrews_2012_ShankboneThe Erin Andrews case has made headline news for months. As the case draws nearer to a close with double-digit million dollar settlement figures being bandied about, taxpayers can learn a few lessons about how in most litigation settlements the IRS gets the biggest cut of all. Between the attorneys’ fees and the IRS tax bill, Ms. Andrews is likely to see little financial gain for the violation of her privacy and for the humiliation she suffered.

According to a recent Forbes.com article, the judge granted Andrews a $55 million settlement. However, between the two parties being sued for damages, the perpetrator, Michael Barrett, doesn’t have the $28 million, which is his share, and The Marriott franchise responsible for the remaining $27 million may appeal. 

One of the most important aspects in this type of lawsuit where damages are being sought is the type of injuries incurred. To be tax free, the injuries must be physical. I’m talking broken bones and other visible damages.

As Forbes.com points out, “Damages for physical injuries (say, broken bones from an accident) are tax-free under Section 104 of the tax code. So are damages for physical sickness. But since 1996, your injury must be “physical” to be tax-free. The IRS says your injuries must be visible, so Ms. Andrews may be out of luck. She was humiliated and clearly suffered emotional distress. But without something considerably more ‘physical,’ it is all subject to tax.” 

Going against the IRS is never an easy thing to do no matter how public your case, no matter how severe the emotional damage. If you don’t incur physical injuries, you have to pay taxes on the settlement. I go up against the IRS pretty much on a daily basis fighting for my clients in tax cases. I know the ins and outs in my area of expertise and know just how far to push without inciting the IRS to push back.  It’s a fine line.

According to Forbes.com, “Taxpayers routinely argue in Tax Court that their damages are sufficiently physical to be tax-free, but the IRS usually wins. Money you receive for physical symptoms of emotional distress (like headaches and stomachaches) is taxed, while physical injuries or sickness is not. But how one should interpret this confusing law is often debated.” 

So Ms. Andrews might appear to be getting a big settlement, but that settlement is going to be taxed as income. In addition, Ms. Andrews won’t be able to deduct her attorney fees either.  That is, unless she ultimately decides to settle out of court. Many cases do settle outside the courtroom because there is much more latitude in how attorneys get paid and how their clients get taxed. As Forbes.com says, “From a tax viewpoint, Ms. Andrews may be better off settling. At least in a settlement the parties can try to agree about the tax issues and tax reporting.” 

The most important aspect of this case is not necessarily the monetary award. Ms. Andrews could have been so humiliated that she wouldn’t take action. However she is doing the brave thing by fighting back and pushing for legal responsibility. That is reward in itself and one the IRS cannot tax.

 

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