The Significant Impact of Interest Taxation as a Settlement Valuation Bridge (October 2023) 

In personal injury claims where the two sides have disparate valuations based in part on substantial interest accrual, there exists an underused tool for bridging the difference and reaching an accord. This tool is the very significant impact of federal, state, and local taxes on the individual plaintiff’s potential award should the matter proceed to verdict and judgment. Mediators, judges, and attorneys alike should always be cognizant of this tool to move cases and reduce the backlog. 

Unlike compensatory damages for physical injury that are not taxable, the interest on the award is taxable income. Moreover, following the Supreme Court’s decision in Commissioner v. Banks, 543 U.S. 426 (2005), individual plaintiffs in contingent-fee cases must generally recognize income equal to 100 percent of their recoveries. This is so even if the lawyer is paid directly by the defendant. Previously, a plaintiff could still deduct the attorney’s fees, but due to the 2017 tax reforms (in effect for 2018-2025), below-the-line deductions of legal fees are no longer permitted. For a more in-depth discussion from an actual tax attorney, please see Robert F. Wood, New Taxes on Plaintiff Gross Recoveries, Not Net After Legal Fees (Nov. 7, 2019). 

https://www.americanbar.org/groups/business_law/publications/blt/2019/11/gross-recoveries/

 Essentially, due to a combination of these two factors, a personal injury plaintiff has to pay income tax on the full taxable amount (i.e., all interest) with no deduction for contingency fees. This tax consequence is obviously a bigger issue in jurisdictions with high interest rates and claims with lengthy interest accrual. For example, depending on the size of the recovery, a New York City plaintiff entitled to 9% simple interest on damages recovery will have to pay an effective tax rate of about 45-47% (or more) on the gross interest sum of about $1 million plus pay attorney’s fees of 33% leaving plaintiff with obligations totaling 78-80% of the interest. (Assuming that the fee arrangement does not contain an increased contingency based on the need to defend an appeal which we have seen in some prominent cases during the recent year.) Thus, plaintiff is not actually getting 9% in simple interest for net or take-home pay, rather, they are getting 1.8%-1.98% of annual interest (20-30% of 9%). We provide a similar chart for the so-called “judicial hellholes” for illustrative purposes with a caveat that effective tax rate will obviously differ based on the individual plaintiff. 

 This, of course, does not account for the increased litigation costs from trial and appeal, increased Workers’ Compensation liens, accruing litigation finance loans, if any, or possible increase in contingency fees should the case proceed to a final judgment. 

 So, for our example of New York, the actual plaintiff’s take-home interest after taxes is only 1.8%-1.98% and their counsel’s take-home interest before taxes is 2.97% (1/3 contingency of 9%). Both of those interest figures are below what a person could receive today from putting their money in a 1-year CD, which is over 5%. Thus, while the insurer might pay more due to New York’s high 9% interest or Illinois’ 6% interest, the individual plaintiff does not actually receive the benefit of that payment and, in today’s marketplace, actually loses money. 

While this phenomenon has not garnered significant attention, Forbes once similarly ran the costs for the $289 million Monsanto verdict, which back then was comprised of $39 million in compensatory damages and $250 million in punitive (taxable) damages. Applying similar arithmetic, Forbes concluded that the individual plaintiff Johnson would only keep about $20 million of the $289 million after attorney’s fees, costs, and federal and California state taxes. See Robert Wood, How IRS Taxes Kill Plaintiff’s $289M Monsanto Weedkiller Verdict, Forbes (Aug. 13, 2018) available at https://www.forbes.com/sites/robertwood/2018/08/13/how-irs-taxes-kill-plaintiffs-289m-monsanto-weedkiller-verdict/?sh=5d78b810402e  

The foregoing, if presented properly, is information that may help serve to resolve matters with substantial interest accrual, and help to resolve them more expeditiously as well. In addition: 

• This analysis is even more imperative where the plaintiff has obtained litigation funding. Between the individual plaintiff’s take-home interest of 2% or less and the loan interest accruing at usurious rates, the take-home value of the plaintiff’s entire claim actually decreases each day that passes.  We have seen this in far too many cases. 

• This analysis also raises important ethics and conflict of interest considerations between the individual plaintiff and their counsel, especially with regard to less sophisticated and brain-injured clients. Rule 1.4 requires that plaintiff counsel advise their clients and their families or representatives of settlement offers but also to “explain the matter to the extent reasonably necessary to permit the client to make informed decisions”. To make a reasonably informed decision, it might be necessary to explain the impact on plaintiff’s share of any judgment or settlement or, at least, raise the issue and refer a client to a tax professional. More simply, the kneejerk tactic of holding firm on a number because “the interest clock is ticking” may serve as leverage against the defendant, and may benefit the plaintiff counsel, but may actually serve to decrease the take-home value of the individual plaintiff’s recovery. This is especially problematic when the case can be settled much earlier at a time when market conditions are favorable for investors.

• This taxation consideration applies in negotiating cases involving claims for punitive damages as well (see Monsanto, supra) as punitive damages are always taxable. 

Initially published in the NYLJ.