Income Gift Tax Planning: Sexual Harassment Settlements

After extensive tax research, I have devised a “cutting edge tax strategy” which is a variation on lawsuit settlements where the settlement is a charitable gift (which type of gift tax planning was recently reported in the Depp-Heard divorce, which according to published reports may have given Depp significant income tax benefits).

In my tax strategy, by characterizing the settlement payment as a gift, the payor may use all or part of their $5.45m (2016) lifetime gift/estate tax exclusion without imposition of a 40% federal estate/gift tax. The recipient receives a “tax free payment”. The payor may be able to negotiate a lower payment settlement amount based on the income tax savings for the recipient (i.e. in California the maximum federal/CA tax “blended tax rate” may be as high as 55% so a $1m payment may only net the recipient $450k after-tax). The payor may take the negotiating position, for settlement purposes, that since the recipient saves $550k in tax on a $1m payment the parties may “split the difference” (i.e. the offer is $725k tax-free subject to negotiated settlement of the final payment amount so each of the parties share in the $550k tax saving pari pasu).

For IRS tax audit purposes, the parties are not precluded from characterizing the payment as a gift if they agree, the business purpose is stated (i.e. the recipient receives a tax-free gift, and the payor uses up all or part of their lifetime estate/gift tax exclusion), the gift characterization is at the request of the payor (not the recipient so it will not appear to be “disguised income”). The “optics” of the settlement in which neither party admits liability but resolve the dispute by a “gift” may post-settlement avert and pre-empt “bad spin”.

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