The trial is over, and the jury just returned an impactful personal injury verdict in favor of your client, $5,000,000 total. $1,000,000 is for compensatory damages and $4,000,000 for punitive damages. It is time to celebrate, but you know the verdict is only one step in the process of recovery. In addition to post-trial motions and potential appellate issues, you also explain to the client that because of the punitive damages award, the IRS is now an interested party. But most concerning, the potential exists that the client’s net recovery will be less than the tax bill from the IRS even though the $1,000,000 in compensatory damages will be received tax-free.
The good news is that you can dramatically reduce the tax consequences with some advance planning. There is a path for your client to walk away with the biggest share of the recovery. We’re going to outline planning options and introduce how to implement the best workable course of action to achieve maximum recovery for the client.
First, here is the estimate of what the net recovery would be to the plaintiff with no planning.
GROSS RESULT – $5,000,000
ATTORNEY FEES – $2,000,000
COSTS & EXPENSES – $250,000
TAX – $1,600,000 (assuming 40 percent total for federal, state and local taxes)
NET TO PLAINTIFF – $1,150,000
The oversized tax bill is the result of two factors. One, your client will be taxed on the entire punitive damages amount. Commissioner v. Banks, 543 U.S. 416 (2005). Two, your client will not be allowed to deduct the applicable attorney fees because of a relatively little-known provision in the Tax Cut and Jobs Act of 2017, which was just made permanent by Public Law 115-97; TCJA. The relevant provisions generally state that the plaintiff cannot deduct attorney fees. This hits plaintiffs receiving taxable damages, punitive damages or post-judgment interest, and compensatory damages in most cases involving claims for breach of contract, defamation, and other non-physical injuries. Plaintiffs can deduct legal fees in cases involving discrimination or when their claims arise from their own business.
How might you avoid this result?
Separate Checks. An idea commonly explored is having the defendant issue separate checks to the plaintiff and to the attorney. The theory behind this idea is the client will just be taxed on the check they receive. This, however, is a misnomer and fraught with danger. Commissioner v. Banks holds that the entire verdict or settlement amount attributable to punitive damages is ordinary income. In other words, it does not matter how the defendant pays the verdict or settlement amount. The plaintiff ultimately must recognize the entire punitive amount as ordinary income. So, the same tax consequences exist even if the defendant is complicit with issuing separate checks. The client still gets taxed as if the defendant issued one check, i.e., taxed on the entire amount.
Separate 1099s. In this scenario, the defendant would make the settlement or verdict payment to your law firm’s trust account and issue separate 1099s to your firm and to the client. However, the Banks case, and IRS regulations, make this option unworkable as well for the same reason that the separate checks option doesn’t work. Because of the Banks holding, the client must recognize the entire punitive damages payment on their tax returns. Even if a 1099 isn’t sent to the plaintiff, that doesn’t protect them from tax liability (or interest or penalties).
Trade or Business Deduction. Another possible creative idea is for the plaintiff to treat the lawsuit as their trade or business, allowing deduction of attorney fees as business expenses under IRC §162. However, this approach fails because the IRS requires regular and continuous activity to establish a trade or business. Commissioner v. Groetzinger, 480 U.S. 23 (1987). A single lawsuit or even occasional litigation does not meet this standard. The IRS would likely challenge this characterization, particularly since the plaintiff’s injury was involuntary rather than part of a profit-seeking enterprise. Of course, if your client is a business owner, or a business, you may be in luck.
Documenting File that Payments are only for Physical Injuries. Assuming the case resolves prior to final judgment, you would implement this option by including provisions in the Settlement Agreement and Release that all payments are for physical injuries. Thus, theoretically all of damages awarded would then be excludible from income taxes under §104 of the Tax Code. However, this is likewise unworkable. The IRS looks to the allocation or ratio of damages in the total verdict when determining what amounts are excludible and/or to be included as ordinary income. IRS Lawsuits, Awards and Settlements Audit Techniques Guide. LeFleur v. Commissioner, T.C. Memo. 19997-312. The defendant is making the settlement payment to avoid liability from the verdict, and the IRS knows that.
Plaintiff Recovery Trust (“PRT”). The creation of this type of trust, offered by Eastern Point Trust Company, is an option that has proven to be workable to maximize the client’s recovery. And it only takes a little bit of planning prior to the judgment becoming final or settlement being paid. The PRT is a split-interest trust, much like a charitable remainder trust – a small percentage fee is charged by the trustee with a portion of the fee going to a charity. The starting point of this option is the plaintiff establishing the trust and assigning the claims or judgment against the defendant(s) to the PRT. The trust then owns the claim and its beneficiary charity is responsible for paying the attorney fee as the fee contract is adopted by the trust. This is ultimately where the tax savings are realized as now the plaintiff no longer owns the claims or judgment. Rather, the plaintiff is merely a beneficiary of the trust. Therefore, they would only be taxed on the amount the client ultimately receives and not on the entire punitive verdict or settlement amount, including the attorney fee portion. The trust need not use deductions lost under the little-known provision in the Tax Cut and Jobs Act (TCJA) that prevents the plaintiff from deducting the attorney fees. Nor does the plaintiff because the charitable trust is the responsible entity to pay any attorney fees. The ultimate result is that the tax burden is significantly reduced. Importantly, the PRT is also accepted by the various life insurance companies that offer structured settlements, a key attribute that allows for the use of multiple tax-saving strategies.
Under the PRT scenario and using same $5,000,000 example as above, here is the tax reduction benefit:
GROSS RESULT – $5,000,000
ATTORNEY FEES – $2,000,000
COSTS – $250,000
TAX – $1,100,000 (assuming 40 percent total for federal, state & local taxes)
PRT COST – $120,000
NET TO PLAINTIFF – $1,530,000
Note: The use of a structured settlement for the punitive damage portion will offer even more tax savings.
SETTING UP THE PRT — THE ADVANCE PLANNING STEPS
The basic steps to establish this type of trust properly are straightforward. The main ones to consider are:
- The plaintiff establishes the trust and transfers the claims or judgment against the defendant(s) to the trust. This transfer must be irrevocable. Attorneys must ensure clients understand that establishing a PRT involves irrevocably transferring their claims to the trust. While clients remain beneficiaries, they technically lose direct control over litigation decisions. The trust technically becomes the client, though pragmatically the original plaintiff remains involved in settlement negotiations and strategic decisions.
- The trust is a valid trust agreement and state law governs the claims.,
- The transfer should occur when genuine uncertainty exists about the outcome. Safe timing indicators include:
- A. Post-verdict, pre-judgment: The period between jury verdict and entry of final judgment provides a clear window when appeals are occurring or possible.
- B. Active appellate potential: Document that realistic grounds for appeal exist, including procedural issues, evidentiary rulings, or damages calculations that could be challenged.
- C. No settlement discussions: Transfers are safest when no concrete settlement negotiations have begun. As the parties close in on a number, uncertainty decreases. Of course, if the parties can still walk away, settlement isn’t certain.
- D. Remittitur possibilities: When it might be argued that damages appear excessive and subject to judicial reduction, uncertainty clearly exists.
- E. Documentation Strategy: Create a contemporaneous record documenting the uncertainties that exist at the time of transfer. This becomes crucial evidence that the transferred asset was merely a right to potential income, not income itself.
- There is no clear planning rule to follow on timing of when to create the trust or make the assignment or transfer. The facts of each case vary. The bottom line is you want the transfer to occur as soon as possible, when the outcome of the litigation is still in doubt, or an option of appeal still exists (even the potential for a writ of certiorari to the U.S. Supreme Court). In other words, you want to leave no doubt that the asset transferred remains just a claim to potential income. This is potentially the most nerve-racking aspect to the course of action, as you wouldn’t want to transfer a judgment to the client’s Plaintiff Recovery Trust and then have the case remanded for a new trial. The jury may not be as sympathetic to the trust as the plaintiff versus the individual. The possibility of case reversal or remand creates legitimate concern about transferring claims prematurely. Your settlement consultant assisting with trust and structured settlement options will help assess this risk by evaluating appeal prospects and timing options.
- The trust has two beneficiaries: (1) the plaintiff and (2) a charity that meets the definition of a charity under the Tax Code. This type of trust has many provisions of a Charitable Remainder Trust. The charity receives a portion of the amount ultimately paid to the trust by the defendant. The plaintiff receives the remainder. The amount going to charity must be material, though not significant.
- The attorney representing the plaintiff enters into a contingent fee agreement with the charity and trust. The contingent fee agreement with the mirrors the original client agreement to avoid any appearance of fee enhancement. Document that the PRT structure benefits the client through tax savings, not increased attorney compensation. The trust owns the claim and is the one that is technically in control of the litigation. The retainer agreement with the PRT helps document this. The cost of the PRT is minimal, typically just 3% of the taxable recovery, ensuring maximum benefit flows to the plaintiff.
The PRT is responsible for the largest funding of the Plaintiff Fund, a path for plaintiffs who would otherwise raise medical funds on GoFundMe. Doing so can jeopardize their Medicaid benefits. Instead, by using the Plaintiff Fund, they receive help and financial support as they seek to raise medical funds from their community.
We are not ignoring the possibility that the Tort Victim’s Compensation Fund may have a lien on the punitive damages’ verdict pursuant to RSMO 537.675. However, such a lien only exists if there is a final judgment. RSMO 537.675.3 provides “The state of Missouri shall have a lien for deposit into the tort victim’s compensation fund to the extent of fifty percent of the punitive damages final judgment which shall attach in any such case after deducting attorney’s fees and expenses.” Thus, if the case is resolved prior to “final judgment,” the Tort Victim’s Compensation Fund via the Attorney General’s office will not have an interest. The PRT also provides a negotiating tool with the defendant(s) as your client has charitable intent already, and if any money goes to the tort victim’s compensation fund, it would likewise benefit others.
CONCLUSION
The Plaintiff Recovery Trust represents a powerful tax planning tool available to personal injury attorneys handling cases involving punitive damage. With proper timing and implementation, clients can recover hundreds of thousands – or even millions – more from their verdicts while contributing a portion to charity. The key is advance planning: once settlement discussions crystallize or final judgment enters, the opportunity may be lost.
Don’t let your clients fall victim to the harsh tax consequences of the Banks decision, TCJA limitations, and the “Big Beautiful Bill.” When facing significant punitive damages, consult with qualified settlement and annuity consultants early in the process to evaluate PRT opportunities. Your clients will thank you for turning a potential tax disaster into maximum recovery as I know mine have.