Recognition of Same Sex Marriage
In United States v. Windsor, (2013) (Docket No. 12307), the Supreme Court held that section 3 of the Defense of Marriage Act (DOMA) is unconstitutional because it violates the principles of equal protection of the Fourteenth Amendment to the US Constitution. It concluded that this section“undermines both the public and private significance of state sanctioned same sex marriages” and found that “no legitimate purpose” overcomes section 3’s “purpose and effect to disparage and to injure those whom the State, by its marriage laws, sought to protect” (Windsor, 133 S. Ct. at 269495). This ruling provides guidance on the effect of the Windsor decision on the Internal Revenue Service’s interpretation of the sections of the Code that refer to taxpayers’ marital status.
Litigation attorneys beware; some settlement awards may be taxable
Some plaintiffs or their lawyers may assume that settlements or awards are tax free. Not so, says Uncle Sam. Internal Revenue Code (IRC) § 61 states all income from whatever source, including lawsuit awards, derived is taxable, unless specifically excluded by another Code section. IRC § 104 is the exclusion from taxable income with respect to lawsuit settlements and awards.
The 1996 amendment added to IRC § 104(a) (2) the word “physical” to the clause “on account of “personal physical injuries or physical sickness”. Therefore, in order for damages to be excludible from income, the judgment or settlement must be derived from personal physical injuries or physical sickness. Prior to the 1996 amendment, IRC § 104(a) (2) was extensively litigated with respect to what was personal injuries.
The litigators are advised to discuss the tax consequences of their potential awards or their settlements structure with a tax attorney before the case is settled, to ensure that their clients will get a tax advantageous settlement, if qualify. A complaint may be filed on the basis of a particular cause of action, if possible. The plaintiffs need to do their own tax planning and be aware of tax ability of their awards and settlements to avoid unnecessary taxes and unexpected AMT trap due to deducing their legal fees on Schedule A subject to 2% limitation. The losing parties should study possible tax deductibility of the settlement or judgment and their legal fees.
Tax Tip: Because of the Windsor holding, all of the tax laws discussed here in are applicable to the Same Sex couples as well.
Tax Tip: If your trial attorney tells you that your settlements / awards are tax free, thank her or him for it, and ask to see the following in the documents:
i) Internal Revenue Code 104(a) (2) or other; ii) Cause of action contained in the complaint; and, iii) Relevant sections of the settlement agreement or court decree referring to non-taxability and the amount.