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Be ready for post-settlement tax issues: once a case is settled, what are the tax implications for your clients, and for you? You don't need to delve deeply into all the complications of tax law, but you do need to know some basics to ensure fair treatment for everyone.

Article Excerpt
Many trial lawyers cringe when discussing taxes, and they are not alone. Few people like paying taxes, much less talking about them. And tax law is complicated and full of pitfalls.

But understanding some tax basics related to settlement is important because often, a small change in a settlement agreement can make a big difference in the size of the tax bite you or your clients face. And an open discussion of a settlement's tax implications can often serve to smooth out a contentious issue that may be getting in the way of the parties' reaching an agreement.

As a trial lawyer, you need to know some tax law--even if you routinely rely on experts, and even if your engagement letter includes a blanket disclaimer that you provide no tax advice. At a minimum, you need to be able to identify potential tax issues when discussing settlement. As you know, the overwhelming majority of cases are settled, and tax-planning opportunities are far more significant when cases are settled than when they go to judgment.

As a tax lawyer, I spend much of my time with trial lawyers and their clients. I believe that every trial lawyer should know a few tax basics:

* how to address tax issues in a settlement agreement

* how attorney fees are treated for tax purposes

* how tax issues affect confidentiality provisions

* how to use qualified settlement funds

* how tax reporting and filing obligations affect the attorney and client Settlement agreement

The agreement itself can have a big impact on how taxes are handled. Of course, you will want to seek to include tax provisions in the agreement that could help your client. Ask a tax lawyer to provide you with the tax comments, so you can transmit all your comments to opposing counsel (on taxes and other issues) at the same time.

For example, suppose you are going to ask defense counsel for payment within five days, and for a tougher confidentiality clause than the one contained in the draft settlement agreement. Ask for any desired tax provisions to be included in the settlement agreement at the same time, which may give you a better chance of getting them accepted.

What tax provisions should you ask for? Litigation recoveries--whether from settlement or judgment--take their tax character from the origin and nature of the claim. If your client is suing for lost wages, the recovery will probably be treated as wages for tax purposes.

If your client is suing for lost profits, lost-profits tax treatment will apply. If your client is suing for diminution in the value of his or her stock portfolio, capital gains treatment (or even recovery-of-basis treatment) may be appropriate.

Ask for tax language in the agreement that is consistent with your theory of the case. This can help secure--or even improve--your client's tax result.

One critical statutory exclusion confuses many trial lawyers. Section 104 of the Internal Revenue Code excludes from taxation recoveries for personal physical injuries. The confusion arises because until 1996, this exclusion applied to any personal injury recovery, including recoveries for nonphysical injuries like defamation, emotional distress, and many others.

In 1996, Congress amended [section]104 to limit the tax exclusion to damages arising from physical injuries or physical sickness. Although this statutory change is now 13 years old, there are no regulations explaining what "physical" means. To be excludable, the IRS says a recovery must be for physical injuries you can see, such as broken bones or bruises. But if you have a legitimate physical injury or physical sickness, emotional distress damages flowing from...