Tax Prophet: FAQ June 23, 1996


Frequently Asked Tax Questions -- June 23, 1996

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, June 23, 1996

Back pay and other wage-related damages


Note: This exercise is for educational purposes only and is not intended to be legal or tax advice. Your particular facts and circumstances must be considered when applying the U.S. tax law. You should always consult with a competent tax professional with respect to your particular situation.

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  1. Question: I received a settlement from my former employer of $50,000 for each count of back-pay and emotional distress caused by sexual harassment. Is this income taxable?


  2. Question: Last column you explained the tax consequences of stock received by inheritance. Do the same "basis" rules apply to stock received from a trust?


  1. Answer to Question #1:

    Back pay and other wage-related damages are always taxable. Damages for "personal injury" (emotional distress, defamation, discrimination) were thought to be non-taxable, but a recent Supreme Court case has cast doubt on that supposition. In response, the Internal Revenue Service has suspended guidance on the tax treatment of damages received from employment-related claims.

    Also, Congress is poised to treat all "non-physical" personal injuries, including emotional distress claims, as fully taxable. The House of Representatives has passed the Small Business Job Protection Act of 1996 (HR 3448) which includes provisions to tax all non-physical injury damages. A similar provision, contained in tax legislation, was vetoed by the president last year. If enacted, the new provision will apply to payments received after June 30, 1996, but will not apply to payments made by an agreement, court decree or mediation award in effect on or before September 13, 1995 ("effective date"). For taxpayers negotiating an employment claim, the time to settle is now.

    Damages for physical injuries or physical sickness will continue their tax-free status. But all payments for "punitive" damages (generally, damages which punish the wrongdoer rather than compensate the victim) received after the effective date will be taxable.


  2. Answer to Question #2:

    It depends on whether the trust was a "grantor trust" (described below) or an irrevocable trust.

    Your basis establishes your tax investment in an asset; it is used to measure your subsequent gain or loss.

    In general, grantor trust rules apply if the trust's creator retains the right to receive the trust property or the discretion to alter, amend or revoke the trust, or has certain powers to distribute the income or principal of the trust. A revocable trust (where the person creating the trust could revoke it) is a common estate planning device in which assets are transferred to the trust to avoid probate, but for tax purposes, the creator is taxed on the trust's income under the grantor trust rules.

    Stock distributions from a revocable trust (and most other grantor trusts) are considered direct transfers from the decedent, so the "stepped-up" basis rules apply. This means your newly inherited basis now equals the fair market value of the stock on the date of the decedent's death (or, in some cases, the FMV 180 days after death). The decedent's estate, however, is subject to estate taxes.

    In contrast, an irrevocable trust is established by a transfer of property (usually by gift or sale) in which the person creating the trust completely parts with ownership and control under "grantor trust" rules (described in previous columns). As an independent taxable entity, it files its own tax returns and is not subject to estate taxes. The beneficiaries receive a "carry-over" basis in the trust's assets. Hence, the trust's basis becomes yours.

    To illustrate: Suppose a trust owns shares with a basis $10 per share, which is now worth $100/share. The trust then distributes the stock to you. If the trust is revocable, your basis is stepped-up to $100/share. If the trust is irrevocable, your basis remains at $10/share. At a later sale of the stock for $150/share, there would be only a $50/share taxable gain under the revocable trust's stepped-up basis rules, but a $140/share taxable gain from an irrevocable trust under the carry-over basis rules.



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    **NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**