The family of the late Kobe Bryant agreed to a $28.5 million settlement with Los Angeles County to resolve remaining claims in their lawsuit over deputies and firefighters sharing grisly photos of the NBA star, his 13-year-old daughter and other victims killed in a 2020 helicopter crash. The figure includes a $13.5 million payment from the county, plus $15 million awarded to Bryant’s widow, Vanessa Bryant, in a jury trial. How does the IRS and the California Franchise Tax Board make out?
The taxman gets a piece of most lawsuit recoveries, and how taxes play out can seem unfair. The basis of the suit was that emergency responders took and shared grisly photos of the bodies, even though the photos were never made generally available to the public. Ms. Bryant accused LA County of negligence and “violating her constitutional right to privacy.” The suit asked for $75M for emotional distress from the photos, but there was apparently no argument that the photos made the plaintiffs physically sick or caused them post traumatic stress disorder. That makes the verdict taxable, but is that after legal fees are subtracted, or before?
Vanessa Bryant testified that news of the photos compounded her grief and that she had panic attacks, but that is probably not enough for a tax exclusion. The payment is taxed as ordinary income, so up to 37% goes to the IRS and 13.3% to California. That cuts the payment in half. And even though Bryant is likely paying her lawyers 40% or so of what she collects, the tax rules for lawyers fees are especially tricky.
Let’s just look at the $15M verdict that we know is directed to Vanessa Bryant. About 40% or so may go to her lawyers, netting her $9M. But the IRS says the whole $15M is taxable even if the lawyers are paid directly, unless she can find a way to deduct the $6M in fees. She might argue that her civil rights were violated so she can write off her legal fees on her taxes, but it’s hardly a certainty. Some plaintiffs end up paying tax on 100%, even though their lawyer collects 40%. Of course, it is better if the money wasn’t taxable in the first place, but that looks tough on these facts. Under the tax code, damages for personal physical injuries or physical sickness are tax free, but damages for emotional injuries are taxable.
So if you sue for intentional infliction of emotional distress, your recovery is taxed. Physical symptoms of emotional distress (like headaches and stomach aches) are taxed, but physical injuries and sickness are not. The rules involve chicken or egg issues with many judgment calls, and what constitutes personal physical injuries or sickness is not defined. The interactions between physical and emotional injuries and sicknesses are starting to be explored, and some plaintiffs in employment suits have had settlements classified as tax-free. Damages for PTSD should arguably also qualify, though the tax law is not clear.
In taxable settlements, the tax treatment of legal fees presents a problem. Since 2018, many plaintiffs are taxed on their gross recoveries, not merely on their net after legal fees. Some call it a new tax on legal settlements. Being creative is needed and checklists of ways to deduct legal fees can help. Why worry about deducting legal fees in the first place? If the lawyer is entitled to 40%, the plaintiff generally will receive only the net recovery after the fees.
But under Commissioner v. Banks, 543 U.S. 426 (2005), if you are a plaintiff with a contingent fee lawyer, the IRS treats you as receiving 100% of the money, even if the defendant pays your lawyer directly. It’s just one of many odd rules about how legal settlements are taxed. A tax deduction for legal fees is easy in employment and whistleblower cases, but in many cases, there is no deduction for legal fees. Some plaintiffs pay tax on monies their attorney collects, even though the attorney must also pay tax on the same money. Bryant can argue for deducting her legal fees since arguably, civil rights are broad and could provide legal fee deductions to cut her taxes.