Some 25,000 lawsuits are filed each year, with most settling out of court. Settling for more starts with demanding more and convincing defendants that juries will agree. At the same time, many employment lawyers also use tax and financial strategies to increase settlement value, all at no cost to defendants. As a result, their clients pay less of their recovery to the IRS, take advantage of subsidized investing, and maximize government benefits.
Employment lawyers get more for their clients through allocations in the settlement agreement, tax deferral, trust arrangements, and other strategies. These solutions can make a “compromise” feel like a “win.”
Allocating in the Settlement Agreement
The typical employment settlement is subject to income tax and employment tax, but less so with “allocations” in the settlement agreement. These allocations explicitly recognize the portion of compensation paid for particular injuries.
Trial lawyers are often advised by plaintiff experts like Greg Maxwell, Esq., CFP®, of Amicus Settlement Planners, who previously served as President of the Society of Settlement Planners. Says Maxwell, “Allocations are invaluable for employment lawyers and their clients because they allow for tax planning.”
Wages are generally subject to employment tax, but the amount of those wages is a question of fact. Since settlements generally compensate for the release of multiple claims, there are often multiple paths to reduce any allocation to wages.
Damages for emotional distress and other injuries are generally subject to income tax. But some such damages are tax-free, including those for any physical injuries, and those compensating for therapy and other medical care. Says Maxwell, “Plaintiffs can often avoid tax on a substantial portion of their settlement.”
Fortunately, allocations receive particular “respect” from the IRS and courts because, under the US Tax Code, they shift the burden of proof to the IRS.
Tax Deferral of Taxable Damages
Since most damages in employment cases are taxable, taking advantage of tax deferral is particularly valuable. Says Maxwell, “Tax deferral spreads taxable income over many years, cutting the plaintiff’s applicable tax rate. And, in addition, it defers taxation of the earnings on the settlement.”
There are many versions of tax-deferred settlement vehicles, typically called “structured settlement annuities.” Tax deferral can be coordinated by name brand insurance companies like MetLife, and funded by their annuities. Or, by private finance companies that invest settlement funds in the plaintiff’s chosen asset class. A 2023 MetLife Survey found that 86% of employment lawyers believe that they should recommend that their clients consider using a “structured settlement annuity.”
Solving the Double Tax in Employment Cases
Since 2018, plaintiffs in many employment cases are unable to deduct their lawyers’ contingent fees and costs. A deduction is only allowed if the lawsuit involves “unlawful discrimination.” As a result, many plaintiffs are taxed on the legal fee portion of their recovery — and then the lawyers pay tax on the legal fees as well. Many call this the “plaintiff double tax,” discussed more in this Forbes article on the taxation of defamation damages.
Eastern Point Trust Company offers the Plaintiff Recovery Trust, a split-interest trust that allows plaintiffs to avoid taxation on the legal fee portion of recoveries. The Trust can facilitate structured settlement annuities, structured attorney fees, and work with qualified settlement funds. Maxwell notes, “The Plaintiff Recovery Trust is our best solution to what is truly an unfair taxation of plaintiffs. Combined with our other strategies, we’re often able to double or even triple our clients’ take-home recovery.”
Conclusion
Employment recoveries are particularly likely to result in a plaintiff keeping far less than half of their “settlement victory.” Through tax deferral and trust-based planning strategies, many employment lawyers have dramatically increased their clients’ after-tax net recoveries..
