Settlement nontaxable only if injury was physical

Q: I am involved in a lawsuit and have received a settlement offer. The suit relates to a hostile environment that my employer created as a result of many unwanted sexual advances. I eventually had to quit working for the employer, and it took me several months to find another job, even though I have an advanced degree in my field. I am still in the same field, and it is hard to avoid him in professional circles. I need the settlement to help fund a move out of state, but taxes would probably kill that plan. Is there some way to phrase the settlement to make it nontaxable?

A: Sometimes it is possible to improve or cement a tax position if a settlement specifies the “right” cause of action that led to the payment. But the language also needs to fit the facts, and I don’t really know the specifics of your situation.

Let me provide you some background that may allow you to initiate a conversation with your lawyer to create a settlement document that attempts to give you the best tax-filing position.

Damage awards, including settlements, are nontaxable if they are received for “personal physical injuries.” Understanding what this includes may be easier if I discuss what it does not include.

Before the 1996 Tax Act, the law said that amounts received for “personal injuries” were nontaxable. Note that this phrase does not use the word “physical” in its description of the injury.

Courts interpreted the phrase “personal injuries” fairly broadly, and approved a tax exclusion for awards for emotional distress, loss of business reputation, and similar issues. Then the Supreme Court limited the scope of the phrase “personal injuries” in a case that denied a tax exclusion for an award for age discrimination.

Following the Supreme Court’s analysis, Congress changed the law to add the word “physical” to the statute, effective Aug. 20, 1996. Since that time, a taxpayer has to show a physical link to the injury to qualify for a tax exclusion.

Unwanted sexual advances may or may not qualify. Post-1996 cases where the injury caused by such advances is purely emotional have not qualified. But an injury that includes physical harm from unwanted advances has qualified.

Any injury that flows from a physical injury will also qualify for the exclusion. For example, if unwanted sexual advances cause a physical harm, and that physical harm then leads to emotional distress, an award that also covers the emotional distress will fully qualify for the exclusion.

But in a case where the victim suffered emotional distress from unwanted advances, and only later did those advances cause a physical injury, only the portion of the award related to the physical injury qualified.

The problem: The emotional distress did not follow the physical injury and therefore did not “flow from” that physical injury.

So I don’t really have an answer for you because you need to evaluate the nature of the injury leading to your settlement in light of the statute. I’m sure your attorney can help you to do this and help craft the language of the settlement.

Q: I missed my firstquarter estimated tax payment and doubled up on the estimate in June for the second quarter. Is this OK, or can I still get an IRS penalty?

You can still be penalized for the first-quarter underpayment. Taxes must be paid quarterly, which translates into rather odd dates of April 15, June 15, September 15, and January 15 of the following year.

The government assesses a penalty if you are delinquent at each quarterly payment date. While this is a penalty, it is computed similar to interest (but is not deductible because it is a penalty).

The current penalty rate is 4 percent. Your April 15 payment was late and was made up by June 15. So, you will be penalized using a calculation that would match a 4 percent interest charge on the underpayment for the two months of delinquency.

You can fix this problem if you have withholdings. Withholdings are deemed paid evenly throughout the year, so a post-April 15 withholding can, in part, be attributed to the first quarter.