Unfortunately, it is not uncommon for a taxpayer to take actions without seeking professional advice, be disappointed with the results, and then seek professional assistance to undo the damage. Often times once the initial action has been taken, there is little or nothing that can be done to correct the ill-advised action of the taxpayer.
Let’s look at the case of Ann McKinney v. Commissioner, TC Memo 2017-6. Ann filed suit that her employer provided a hostile working environment based on age and disability. About two years later, the two parties entered into a settlement agreement whereby she withdrew her suit and the employer agreed to pay her a lump-sum payment of $40,000. The agreement stated that Ann held the responsibility to report the amount received for income tax purposes.
The employer issued Ann a Form 1099-MISC (as required by law) reporting as taxable income the $40,000 amount agreed to in the settlement. Ann did not report this income on her personal tax return. Ann later filed an amended Form 1040-X, but again failed to report the $40,000 of income received. The IRS eventually sent Ann a notice of tax deficiency for her failure to report this income.
Ann then argued that the $40,000 was not taxable to her claiming that the payment received was due to physical injury or physical sickness. In reaching its conclusion that the income was taxable to Ann, the court looked to the nature of the claim settled. It first examined the settlement agreement. It then looked beyond the agreement for other evidence indicating the intent of the payer as to the purpose of making the payment. Such factors as the amount paid, the factual circumstances that led to the settlement, and the allegations in the employee’s complaint or amended complaint. Looking at all the evidence, the court agreed with the IRS that the $40,000 was taxable compensation.
This case illustrates two fundamentals that taxpayers should follow. First, when making a financial decision, be sure to first consult with an experienced tax professional. Second, if you have engaged an attorney and s/he is not consulting with your tax professional, perhaps you are working with the wrong attorney. While winning a law suit is very important, the taxability of that suit is likewise very important. If this settlement had been arranged in a manner that payment satisfied the physical injury or physical sickness requirement, Ann would have avoided almost $10,000 in federal taxes.
If you would like to discuss your business or personal tax planning, tax preparation and other financial concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.
