The IRS audit guide on lawsuit awards and settlements is part of the agency’s revamped approach to auditing, the Market Segment Specialization Program (MSSP). The fundamental objectives of the MSSP are to increase voluntary taxpayer compliance and to help IRS examiners perform audits more efficiently and effectively by providing technical tax and compliance guidelines for specific industries, classes of taxpayers, or issues (see “The IRS Market Segment Specialization Program,” The CPA Journal, February 2001). This most recent audit guide differs from previous guides in that it does not relate to a specific industry or market segment, but rather to a narrow issue that applies only to individuals.

This audit guide resulted from a project concerning a large number of lawsuits in Alabama that had been resolved by verdict or settlement. Early results of the project indicated that most of these substantial lawsuit payments were not reported as taxable income. Hence, this guide was developed to provide lists of issues, explanations of applicable terminology, information on the identification of tax returns with lawsuit payment issues, suggestions for conducting the examination, synopses of related court cases, and exhibits of pertinent forms.

The Audit Guide

The audit guide consists of ten chapters and four appendices. The main issue, the taxability of lawsuit payments, seems relatively simple. IRC section 104(a)(2) specifically addresses income exclusions for any type of lawsuit payments. Prior to 1996, this section excluded from income lawsuit payments for personal injuries or sickness. IRC section 104(a)(2) was amended in 1996 to clarify the taxability of punitive damages without regard to their connection to a physical or nonphysical injury or sickness. The 1996 changes also limited amounts excludable for emotional distress to out-of-pocket medical costs in cases of nonphysical injuries (such as discrimination). The audit guide applies to both pre- and post-1996 lawsuit payments.

The potential audit issues related to lawsuit proceeds are presented in Chapter 1 of the audit guide:

Chapter 2 defines the types of claims, damages, and settlements and gives the appropriate tax treatment. Payroll and self-employment tax considerations, deductions for legal fees, and accrued interest on court judgments are discussed in Chapter 3. Identifying taxpayers that have received large lawsuit payments may be a difficult task because a Form 1099 may not be issued to the plaintiff. In Chapter 4, the audit guide suggests sources of information such as newspaper articles, courthouse files, state agencies’ computerized case files, state departments of insurance, and state supreme court libraries. Third parties, particularly insurance companies, may be a source of a variety of useful information. Chapter 5 of the audit guide presents various devices for obtaining such information.

Building the case file and the examination action plan are described in Chapters 6 and 7. The case file should include the original complaint and pleadings, the settlement agreement or release, the disbursement schedule or a clear statement of how funds were disbursed, and a copy of the attorney’s fee arrangement agreement. For cases involving out-of-court settlements, a determination of the allocation of proceeds between compensatory and punitive damages is critical. Items to be considered in making this determination are the payer’s intent, the nature of the claim, negotiations between the plaintiff and the defendant, the amount it would take to make the plaintiff whole, and verified amounts spent for medical treatment for mental pain and anguish. Chapter 7 also contains a sample calculation of deductible legal fees and court costs based on the ratio of taxable proceeds to total proceeds.

The possible penalties to be considered by examiners are discussed in Chapter 8, and Form 1099 reporting requirements are reviewed in Chapter 9. Finally, Chapter 10 is an eight-page summary (with citations) of pertinent litigated cases.