Before You Sign the Settlement Agreement: Don't Overlook the Tax Consequences

By Averi A. Niemuth and Van U. Donkersgoed

Settling a legal dispute may bring closure to the parties involved, but it does not necessarily resolve the tax consequences.

A recent U.S. Tax Court decision, Eiler v. Commissioner, is an important reminder that the IRS is not bound by how parties characterize payments in a settlement agreement. Instead, courts look to the underlying claims that gave rise to the payment—a long-established tax principle known as the origin-of-the-claim doctrine.

For employers, employees, and their advisors, that distinction can carry significant financial consequences. Whether resolving an employment dispute or another civil matter, thoughtful planning before signing a settlement agreement can help reduce uncertainty, support the intended tax treatment, and avoid costly surprises later.

A Reminder from the Tax Court

In Eiler v. Commissioner, the taxpayers settled claims brought under the Fair Credit Reporting Act (FCRA). They argued that portions of their settlement, including attorney's fees paid directly to their attorneys, should not be included in their taxable income.

The Tax Court disagreed.

Because the settlement agreements provided lump-sum payments without allocating amounts to the various claims, the court treated the entire recovery as taxable. The court also confirmed that attorney's fees paid directly to counsel may still be treated as taxable income to the plaintiff under longstanding federal tax principles.

While the decision arose from an FCRA dispute, its broader lesson applies to virtually every negotiated settlement.

Tax consequences are determined by the substance of the underlying claims, not simply by the language used in the settlement agreement or who receives the payment.

Understanding the "Origin of the Claim" Doctrine

The origin of the claim doctrine asks one straightforward question:  What was the payment intended to compensate?

The answer generally determines how the payment will be taxed.

If the payment compensates for taxable economic losses, it is generally taxable. If Congress has specifically excluded that category of recovery from income, different tax treatment may apply.

Settlement language remains important, but it cannot override the facts. Courts—and the IRS—look beyond labels to determine the payment's true nature. As Eiler demonstrates, when settlement agreements fail to identify the purpose of specific payments, taxpayers may lose the opportunity to obtain more favorable tax treatment.

Why Employers Should Care

Employment settlements often resolve multiple types of claims at once. A single agreement may include payments for wages, emotional distress, statutory damages, attorney's fees, physical injuries, interest, and other claims.

Each category may carry different tax consequences.

When settlement agreements fail to distinguish among those claims—or when the allocations do not reflect the underlying facts—the parties risk future disputes with taxing authorities and unintended tax liability.

Proper planning can help reduce that risk.

Understanding Common Employment Settlement Payments

Physical Injury Damages

Damages received for personal physical injuries or sickness may qualify for exclusion from gross income under Internal Revenue Code Section 104(a)(2).

When a settlement includes physical injury damages, the agreement should accurately describe the factual basis for that allocation. Contemporaneous medical records and other evidence often play an important role in supporting the intended tax treatment.

Most Other Employment Recoveries

Many other employment-related recoveries—including back pay, front pay, emotional distress damages unrelated to physical injury, statutory damages, interest, and contractual payments—are generally taxable.

Wage-related payments also typically require payroll tax withholding and Form W-2 reporting.

Settlement agreements, payment procedures, and tax reporting should all consistently reflect the nature of the underlying claims.

Practical Steps That Can Help Avoid Unintended Tax Consequences

Well before the settlement agreement is signed, employers and their advisors should consider how the claims being resolved may affect tax reporting and compliance.

Some practical considerations include:

Identify Tax Issues Early

Evaluate the categories of claims during settlement discussions—not after the agreement has been drafted. Understanding whether payments relate to wages, statutory claims, physical injuries, attorney's fees, interest, or other damages helps inform both negotiations and documentation.

Build a Record That Supports the Settlement

The complaint, correspondence, medical documentation, witness statements, and other contemporaneous evidence should support the characterization of each claim. Courts are generally skeptical of efforts to recharacterize payments after a settlement has been reached.

Allocate Payments Thoughtfully

Where appropriate, settlement agreements should include reasonable, good-faith allocations that reflect the claims being resolved. If physical injury damages are included, the agreement should briefly explain the factual basis for that allocation.

Consider Attorney's Fees Carefully

Directing payment to a plaintiff's attorney does not automatically exclude those amounts from the plaintiff's taxable income. Whether deductions or other tax treatment are available depends on the underlying claims and applicable tax law.

Ensure Tax Reporting Matches the Agreement

Settlement agreements, Forms W-2 and 1099, payroll reporting, and payment procedures should tell a consistent story. Consistency across documentation helps reduce audit risk and supports the parties' reporting positions.

Keep the Entire Agreement Consistent

Confidentiality provisions, reference agreements, reinstatement rights, non-cash consideration, and other settlement terms should align with the agreement's overall structure. A consistent approach strengthens the settlement's credibility if it is later examined by taxing authorities.

Better Outcomes Through Collaborative Counsel

Employment disputes rarely involve only employment law.

They often raise tax, payroll, benefits, insurance, and business considerations that affect a settlement's overall value. Addressing those issues together—not sequentially—can lead to better-informed decisions and fewer surprises after the agreement is signed.

At DeWitt, attorneys regularly work across practice areas to help clients navigate these interconnected issues. By combining employment and tax perspectives early in the settlement process, clients can better assess risk, structure agreements more thoughtfully, and position themselves for more predictable outcomes.

Averi Niemuth represents employers in workplace disputes, employment litigation, and day-to-day employment counseling, including matters involving discrimination, harassment, wage-and-hour issues, and other workplace issues. Van Donkersgoed focuses his practice on tax controversy and litigation, helping individuals and businesses resolve complex federal and state tax disputes. Together, they help clients evaluate settlement strategies that align legal objectives with potential tax consequences.

Key Takeaways

• Settlement labels alone do not determine tax treatment. Courts look to the underlying claims and the facts supporting the recovery.
• Careful planning before an agreement is signed matters. Well-supported allocations and consistent documentation can help support the intended tax treatment and reduce future disputes.
• Employment and tax issues are closely connected. Addressing both together often results in stronger agreements, more predictable reporting, and better business outcomes.

Looking Beyond the Settlement Agreement

A settlement agreement is often seen as the final step in resolving a dispute. Eiler reminds us that it should also be viewed as the start of the parties' tax reporting obligations.

By considering the tax implications alongside the legal issues during negotiations, rather than after the agreement is finalized, employers and employees can reduce uncertainty and better protect their interests.

Whether resolving an employment dispute or another complex civil matter, involving both employment and tax counsel early can help ensure the agreement reflects not only the parties' legal and business objectives but also the tax rules that ultimately govern the outcome.