Robert W. Wood (Robert W. Wood, P.C., San Francisco) has published Defendants in Litigation Should Worry About Nondeductible Settlement Payments, also available on the Tax Analysts web site as Doc 2005-3447, 2005 TNT 35-33. Here is part of the opening:

Whether a case is concluded by settlement or by judgment, after verdict and appeal, or before the complaint is even filed, some thought should always be given to the tax consequences of the payment. Those are not small points, either, but are fundamental questions that should be asked on any payment.

Is it income to the plaintiff, and if so, is it capital, ordinary, or wages? Is it deductible to the defendant, or must it be capitalized? Is it subject to withholding? For both plaintiff and defendant, how should the inevitable attorney fees be treated?

Today this analysis increasingly involves tax reporting issues as well. Apart from more traditional Form W-2 and Form 1099 rules requiring information returns to the plaintiff, the prevalence of gross receipts reporting to attorneys (as well as their clients) raises compliance issues that often must be addressed before cutting the checks. Failing to address those issues upfront can mean horrifying surprises and can cause settlements to sometimes unravel. When the defendant is trying to pay a judgment, its tax treatment (withholding, for example), can prompt renewed litigation between the parties. A defendant who has been battered in litigation and who is prepared to pay the judgment will be none too happy to be caught up in subsequent litigation with the same plaintiff over a failure to agree on tax issues. Trying to join the IRS in the suit to have it resolve it is futile, because the Service refuses to join any private litigation.

Despite all of the reasons a defendant should be concerned with these rules, the fact remains that plaintiffs are far more likely than defendants to raise tax issues. Plaintiffs are also far more likely than defendants to hire tax counsel to assist in the process. Part of that phenomenon may be attributable to the fact that many defendants are businesses and already have tax advisers. However, in my experience, the tax advisers are rarely brought into the litigation process, or even consulted, until after the settlement or judgment has been paid, when it comes time to address tax reporting issues.