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Birmingham Bar Association Bulletin | Winter 2014

Tax Law In Burford v. United States a federal court held that a recovery of punitive damages for wrongful death in Alabama was excludable from income. This exclusion only applies to wrongful death; other punitive damages are treated as taxable. Damages for non-physical injuries like injury to reputation and discrimination are taxable. In a wrongful termination case back pay for services by an employee would also be taxable and would be characterized as wages for employment tax purposes. Business-related damages such as a contract breach or lost profits are taxable as well, as is interest added to any award, even if tax-free. In some cases the line between taxable and non-taxable is less distinct. In one case a former employee was awarded damages for wrongful termination. The employee suffered from multiple sclerosis, which worsened during the latter part of her employment due to job-related stress. A settlement was reached with a portion allocated to wages and the remainder reported to her on a 1099-MISC. The employee reported the wages on her return and excluded the 1099 amount as nontaxable. She was subsequently audited by the IRS. The tax court agreed with the taxpayer and found the amount reported on the 1099 to be excludable since the stressful work environment worsened her physical illness. What to include in gross income I’m often asked if a taxpayer can exclude from income a contingent fee payment made to an attorney. The answer is no. Under the long-established fruit of the tree principle, income is assigned to the one who earns it and cannot be assigned to someone else. In 2005 the Supreme Court found in Banks that the contingent fee payment in a taxable award cannot be excluded from income. The litigant must include the entire amount in gross income— netting is not allowed. In part two of this article I will share some case studies provided by the IRS in their Treasury Regulations, which is the codified interpretation of actual cases that have come before the service. G CPA Mike Baker is Managing Partner of Dent, Baker & Company. He joined the firm in 1989. A Certified Financial Planner, Mike is a member of AICPA and the Alabama Society of Certified Public Accountants. Reach him at Mbaker@dentbaker.com. AL-SPAD0408095641 Birmingham Bar Bulletin/ Winter 2014 13


Birmingham Bar Association Bulletin | Winter 2014
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