TAX CONSEQUENCES OF JUDGMENTS
AND SETTLEMENTS
Prepared by:
Peter J. Marmo and W. Matthew Carver
Crady, Jewett & McCulley, LLP
Presented by:
Peter J. Marmo
Telephone: (713) 739-7007
Telefax: (713) 739-8403
Email: pmarmo@cjmlaw.com
Table of Contents
Page
I. INTRODUCTION .......................................................................................................................1
II. THE ORIGIN & NATURE OF CLAIM ....................................................................................2
III. CODE SECTION 104 – COMPENSATION FOR INJURIES OR SICKNESS ......................4
1. PHYSICAL PERSONAL INJURIES OR PHYSICAL SICKNESS ..............................5
a. Physical Personal Injuries or Sickness ................................................................5
b. “On Account Of” Nexus .....................................................................................5
c. Mental Distress....................................................................................................6
d. Medical Expenses ...............................................................................................7
2. ACCIDENT OR HEALTH INSURANCE .....................................................................7
3. WORKMEN’S COMPENSATION ACTS ....................................................................8
a. Qualified Law Requirement ................................................................................8
b. Occupational Injuries Requirement ..................................................................10
c. Presumptions as to Nature of Injury..................................................................10
d. Age, Length of Service or Prior Contributions .................................................11
4. PAYMENTS RECEIVED AS A PENSION OR ANNUITY FOR PERSONAL
INJURIES SUFFERED BY “MILITARY” PERSONNEL ..................................12
5. DISABILITY PAYMENTS FOR INJURIES SUFFERED IN TERRORIST
ATTACKS .............................................................................................................14
6. MISCELLANEOUS CONSIDERATIONS..................................................................14
a. “Wages” ............................................................................................................14
b. Unallocated Amounts........................................................................................14
c. Punitive Damages..............................................................................................15
d. Periodic Payments and Prejudgment Interest ...................................................16
IV. AMOUNTS RECEIVED IN NON-PERSONAL INJURY CASES ......................................16
1. ORDINARY INCOME OR CAPITAL GAIN .............................................................17
V. DEDUCTION OF PAYMENTS BY THE PAYOR ................................................................18
1. BUSINESS EXPENSES ...............................................................................................18
2. PRODUCTION OF INCOME EXPENSE DEDUCTION UNDER CODE SECTION
212..........................................................................................................................18
3. FINES AND PENALTIES ...........................................................................................19
VI. LEGAL FEES .........................................................................................................................19
1. CONTINGENT FEE ARRANGEMENTS ...................................................................20
a. History ...............................................................................................................20
b. Banks/Banaitis ..................................................................................................22
c. American Jobs Creation Act of 2004: ...............................................................23
VII. CONSISTENCY IN TAX REPORTING CLAUSES ...........................................................25
i
I.
INTRODUCTION
Civil disputes between parties are resolved by utilization of the judicial1 process, or
settlement is reached prior to either party invoking the judicial process. Once a court’s
jurisdiction is invoked, the dispute is usually concluded in one of two ways: (i) a judgment is
rendered, or (ii) the parties arrive at a settlement before a judgment is actually rendered. If the
dispute results in a judgment, oftentimes in order to avoid the appeals process, the parties enter
into a settlement agreement. However, from a tax standpoint, it does not matter whether
litigation is resolved through a judgment or a settlement. As long as the payment is not
voluntary (e.g., it must be result of a bona fide dispute), the tax treatment of money or property
received pursuant to the resolution of a dispute is the same under either scenario.2 In the analysis
of a settlement, there must be an enforceable claim by the parties that, to the extent feasible,
produces an economically fair result.3 Generally, the settlement must also be within the range of
reasonable outcomes under any governing instruments and applicable state law addressing the
issues resolved by the settlement.4
Taxable income is generally determined by subtracting a taxpayer’s allowable deductions
from gross income. Accordingly, gross income is a fundamental factor in the determination of
federal income tax liability. Code Section 615 provides that gross income includes “income from
whatever source derived.”6
Money or property received pursuant to a judgment or settlement is an accession to
wealth, clearly realized, and over which the recipient has complete control. Therefore, it is
includible in the recipient’s gross income under Code Section 61 and the rationale set forth by
the United States Supreme Court in Glenshaw Glass. In that regard, the Supreme Court
articulated its position as follows: “Here we have instances of undeniable accessions to wealth,
clearly realized, and over which the taxpayers have complete control. [The circumstances of its
acquisition] cannot detract from their character as taxable income to the recipients.” Id. There is,
however, a limited exclusion under Code Section 104 for amounts received pursuant to the
resolution of certain personal injury claims. The exclusion is limited to damages received “on
account of” a physical personal injury or sickness.
1
For purposes of this paper, a quasi-judicial proceeding, although possibly non-appealable (such as an
arbitration), shall be grouped into the discussion of a normal judicial proceeding.
2
Murphree v. U.S., 88-1 USTC ¶ 9292 (N.D. Tex. 1988), rev’d & rem’d, 867 F.2d 883 (5th Cir. 1989). See
also Longino Est. v. Comr., 32 T.C. 904 (1959) (settlement); Levens v. Comr., 10 T.C.M. 1083 (1951)
(arbitration award).
3
Ahmanson Foundation v. United States, 674 F.2d 761, 774-75 (9th Cir. 1981).
4
Regs. Section 26.2601-1(b)(4)(i)(B).
5
All references to “Code” are to the Internal Revenue Code of 1986, as amended, and the regulations
promulgated thereunder.
6
Comr. v. Glenshaw Glass, 348 U.S. 426, 431 (1955).
1
In all other cases, the issue generally is not whether the recovery is excludable from gross
income but whether it is ordinary income, capital gain, or return of capital. Further, the analysis
is sometimes complicated by the fact that a single cause of action may involve multiple claims,
each requiring a different result, and hence, an allocation of the recovery among various claims.
From the payor’s perspective, payments made pursuant to a judgment or a settlement may
be deductible as (i) trade or business expenses under Code Section 162, or (ii) production of
income expenses under Code Section 212; provided all the requirements of those provisions are
satisfied. Instead of a current deduction, the payor, however, may be required to capitalize the
payments if the claim pertained to the sale or exchange of a capital asset.
II.
THE ORIGIN & NATURE OF CLAIM
In order to determine the appropriate tax treatment of a recovery both from the recipient’s
perspective and from the payor’s perspective, the origin and nature of the claim must be
analyzed7. If, after considering the origin of the claim, it appears that the payments are
includible in gross income (or are deductible by the payor), then the nature of the claim would
dictate whether the payments should be includible as ordinary income or capital gain (or should
be deductible by the payor currently or over a longer period of time, respectively). In this regard,
if the origin of the claim is a nonpersonal business injury (e.g., breach of contract), the recovery
is clearly includible in gross income. However, if the origin of the claim is a physical personal
injury (e.g., a bodily injury suffered while on the premises of another), any recovery received on
account of such injury is clearly excludable from gross income under Code Section 104(a)(2).
The basic function of the origin and nature of the claim doctrine is to restore the plaintifftaxpayer to the same position taxwise that she would have been in had the injury in question not
occurred. The Service8 seeks to achieve this objective (as set forth in the Code and regulations)
by treating the amount received in satisfaction of a claim as a substitute for the damage suffered
in connection with the claim and assigning it the same tax treatment that the lost income item
would have received had the loss not occurred.
Example: Company terminates the services of one of its Employees who is employed
pursuant to an employment contract. Employee brings a claim for breach of
her employment contract. Without filing a lawsuit, Employee writes a demand
letter to Company demanding two types of relief: (i) reinstatement, and (ii)
lost wages. The parties settle their dispute and Company agrees to: (i) rehire
Employee, and (ii) pay Employee $10,000 in back pay. Since the origin of the
claim in this case is a breach of employment contract, Employee is clearly
alleging a nonpersonal injury and, as such, $10,000 is includible in
Employee’s gross income. Employee still must determine whether $10,000 is
includible as ordinary income or capital gain. Upon reviewing the nature and
the character of the claim underlying the $10,000 settlement payment, it is
apparent that this amount was intended to compensate Employee for lost
wages. Therefore, Employee must include it in income as wages.
7
8
U.S. v. Gilmore, 372 U.S. 39 (1963).
All references to the “Service” are to the Internal Revenue Service.
2
The same type of analysis is applied to determine whether a deduction is available to the
payor (i.e., the defendant), and, if so, whether the payments are deductible currently or must be
capitalized. Therefore, in the example above, since Company is engaged in a trade or business
and Employee’s claim arose in connection with Company’s trade or business, the Company may
deduct $10,000 as a trade or business expense under Code Section 162.
A different issue exists in the case of capital assets. If the underlying recovery was
intended to compensate the plaintiff-taxpayer for the loss of (or harm to) a capital asset, capital
gain treatment is not always guaranteed. The plaintiff-taxpayer must also establish that the
payment meets the “sale or exchange” requirement of Code Section 1221. If the “sale or
exchange” requirement is not satisfied, the payments received by the plaintiff-taxpayer must be
treated as ordinary income.9
Further, even if the payments are received by the plaintiff-taxpayer in settlement of a
claim for loss of, or damage to, a capital asset and the “sale or exchange” requirement of Code
Section 1221 is met, it does not necessarily follow that the entire amount is treated as capital
gain. To the extent the plaintiff-taxpayer has basis in the lost or damaged capital asset, the
recovery is treated as a return of capital (subject to ordinary income recapture as discussed in
Section IV.1., below).
One method to determine the origin and nature of the claim, or portions thereof, is to
examine the (i) basis for the plaintiff-taxpayer’s claim (i.e., latest live pleading, such as a filed
petition); (ii) history of the negotiations and if the parties have entered into settlement
discussions; and (iii) terms of the settlement agreement.10 The Service has stated that the
document, if any, filed with the Court is persuasive evidence of how payments received pursuant
to a judgment or a settlement should be characterized.11 However, scrutiny may increase if the
document filed by the Court was filed just prior to the settlement.
If the plaintiff-taxpayer makes several different claims, then it is necessary to determine
the exact amount properly allocable to each claim. An analysis of the nature and character of
each claim is required because amounts allocable to different claims may be characterized
differently from a tax standpoint. For instance, if a plaintiff-taxpayer receives a recovery
pursuant to a judgment or settlement on account of loss of profits and loss of or damage to a
capital asset, the amount received on account of lost profits is characterized as ordinary income.
However, the amount received on account of loss of or damage to a capital asset may be
characterized as partly return of capital and partly capital gain. A precise allocation of the
recovery to lost profits, lost or damaged capital asset and the plaintiff-taxpayer’s basis in the
capital asset must be made.
9
Rev. Rul. 74-251, 1974-1 C.B. 234.
10
1985-2 C.B. 51. However, simply mentioning a particular personal injury in a complaint, without more (such
as supporting facts), does not guarantee the application of Code Section 104(a)(2). See Kightlinger v. Comr.,
T.C. Memo 1998-357.
11
Rev. Rul. 85-98.
3
In the case of a settlement, the parties may attempt to allocate precise amounts to the
various claims made by the plaintiff-taxpayer. It should be noted, however, that allocations
made by the parties to a settlement agreement are still contestable by the Service. 12 Where a
dispute is resolved through a judgment, the court order may make an allocation of the total
amount of the recovery among various claims, but this is unusual. In any event, the Service may
refuse to accept a judge’s written findings (whether they be set forth in a judgment or findings of
fact) as conclusive on the characterization issue.
III.
CODE SECTION 104 – COMPENSATION FOR INJURIES OR SICKNESS
Code Section 104 addresses the taxation of amounts received in connection with injuries
or sickness. Provided the harm is physical (rather than non-physical injuries such as mental
anguish unrelated to actual physical injuries), payments received in this regard are generally
excludable from the plaintiff-taxpayer’s gross income.
Specifically, pursuant to Code Section 104, an exclusion from gross income is available
in connection with the following amounts received:
12
13
(i)
as damages (other than punitive damages) on account of physical
personal injuries or physical sickness;13
(ii)
in connection with accident or health insurance for personal
injuries or sickness;14
(iii)
under workmen’s compensation acts and which relate to
compensation for personal injuries or sickness;15
(iv)
as a pension, annuity, or similar allowance for personal injuries or
sickness resulting from active service in the armed forces;16 and
(v)
as disability income attributable to injuries suffered in certain
terrorist attacks.17
(vi)
Upon the death or permanent disability of a public safety officer,
or under the laws of any state providing for monetary
Even in light of the parties’ agreements regarding allocation, they must be reasonably supported by the facts.
Maryland Shipbuilding and Drydock Co. v. U.S., 409 F.2d 1363 (Ct. Cl. 1969).
Code Section 104(a)(2).
14
Code Section 104(a)(3).
15
Code Section 104(a)(1).
16
Code Section 104(a)(4), (b)(1).
17
Code Section 104(a)(5).
4
compensation for the surviving family of a deceased public safety
who dies in the line of duty.18
An analysis of each of these categories is provided below.
1.
PHYSICAL PERSONAL INJURIES OR PHYSICAL SICKNESS
Damages (other than punitive damages as described in Section III.6.c., below) received
pursuant to a judgment or settlement of a claim for personal injury or sickness are excludable
from gross income only if such injury or sickness is physical.
Note: The word “damages” includes amounts awarded by a court in a lawsuit as
well as amounts received as the result of an agreement in settlement of a
suit.19 However, the exclusion is not available in the case of damages
awarded to a corporation, because a corporation cannot sustain “personal”
injuries.20
a.
Physical Personal Injuries or Sickness.
As noted, an exclusion from gross income under Code Section 104(a)(2) is
available only if the personal injury or sickness alleged by the plaintiff-taxpayer in his or her suit
is physical. Personal physical injuries include those which result in observable bodily harm such
as bruises, cuts, swelling, and bleeding.21 Damages received as a result of non-physical personal
injuries, such as wrongful termination, age, race or sex-based discrimination, constitutional torts,
or loss of reputation, are not excludable from gross income. Emotional distress does not qualify
as a physical injury supporting an exclusion.22 The regulations distinguish between emotional
distress attributable to a physical injury or physical sickness, which are excludable, from other
types of emotional distress. As discussed in Section III.1.d. below, there is an exception under
which medical expenses incurred to treat mental distress qualify for an exclusion under Code
Section 104(a)(2).
b.
“On Account Of” Nexus.
Simply alleging a physical personal injury does not guarantee excludability from
gross income. In order to be excludable under Code Section 104(a)(2), each element of the
damages award must also satisfy the “on account of” requirement set forth in the Supreme
Court’s decision in Schleier.23 To satisfy this requirement, there must be a nexus between each
18
19
Code Section 104(a)(6).
Code Section 104(a)(2).
20
P & X Markets, Inc., 106 TC 441, Dec. 51,400 aff’d, CA-9 (unpublished opinion), 98-2 USTC ¶ 50,613.
21
See PLR 200041022.
22
Code Section 104(a).
23
Commissioner v. Schleier (94-500), 515 U.S. 323 (1995).
5
element of the damages award and the physical personal injury or sickness alleged by the
plaintiff-taxpayer. In most instances, where the plaintiff-taxpayer suffers a physical personal
injury, all damages flowing from such injury are excludable from gross income under Code
Section 104(a)(2).24
Example:
Worker is injured as a result of faulty scaffolding upon which he
was working coming apart. As a result of the injuries sustained,
Worker misses several weeks of work. Worker brings a suit under
the applicable state statute which, besides other remedies, provides
that in all actions brought to recover damages for personal injuries
Worker may also claim pre-judgment interest on the damages
calculated from the date the suit is brought to the date the judgment
is satisfied. In Worker’s petition filed with the court, Worker cites
and invokes the application of the state statute on pre-judgment
interest.
The parties reach a settlement under which the
manufacturer of the scaffolding agrees to pay Worker $100,000 in
damages. The settlement agreement allocates the payment as
follows: (i) $10,000 to lost wages, (ii) $20,000 to medical
expenses, (iii) $65,000 to pain and suffering, and (iv) $5,000 to
pre-judgment interest. Damages received for lost wages, medical
expenses and pain and suffering satisfy the “on account of”
requirement and, therefore, are excludable from gross income.
Prejudgment interest (which is further discussed in Section III.6.d.
below), however, is not excludable from gross income because it is
compensation for lost time value of money and is not received on
account of a physical personal injury.
Further, it is not necessary that the taxpayer suffer the injury herself. An exclusion under
Code Section 104(a)(2) may be claimed for damages received on account of a physical personal
injury suffered by another (such as in a loss of consortium context).
c.
Mental Distress.
Damages for mental distress (including the physical symptoms of mental distress)
are not usually treated as damages on account of a personal physical injury or sickness, except to
the extent of the amount paid for medical care attributable to mental distress. However, damages
for mental distress and other non-physical injuries or sickness remain excludable to the extent
attributable to a physical injury or sickness.25
Example:
Husband is injured in a slip and fall incident at the hardware store.
Husband’s injuries incapacitate him. Husband and his Wife
successfully pursue a legal claim and Husband recovers damages
for his physical injuries, medical costs, mental distress and loss of
24
See e.g., PLR 200121031; but see Johnson v. U.S., 228 F. Supp. 2d 1218 (D. Colo 2002).
25
Code Section 104(a).
6
consortium with Wife. Because the mental distress damages
awarded to Husband were on account of his physical injuries, all of
the damage awards are excludable from income.
d.
Medical Expenses.
A plaintiff-taxpayer may not take both a deduction and an exclusion for the same item.
Thus, to the extent the plaintiff-taxpayer claimed a medical expense deduction in a prior taxable
year, an exclusion under Code Section 104(a)(2) is not available for amounts received pursuant
to a judgment or a settlement for medical expenses received on account of a physical personal
injury or sickness.
2.
ACCIDENT OR HEALTH INSURANCE
Amounts received by a plaintiff-taxpayer through accident or health insurance (or another
arrangement which has the effect of accident or health insurance) for personal injury or sickness
are excludable from gross income, except to the extent (i) the premiums were paid by the
“employee’s” employer directly, or (ii) paid by the “employee’s” employer through contributions
that were not included in the “employee’s” gross income.26 In the application of the above
exclusions, the term “employee” does not include a self-employed individual (i.e., a member of a
partnership or the sole proprietor of an unincorporated business), even though such a person may
be treated as an employee for other purposes.27 For instance, a partnership’s reimbursement of
the medical expenses of a partner is considered to be a distribution of partnership profits or, in
some cases, as a guaranteed payment described in Code Section 707(c). In either event, it is
included in the partner’s gross income.
However, a different result is reached when the self-employed individual or partner pays
the premiums on a contract of health or accident insurance for the benefit of a self-employed
person. In these instances, the self-employed individual or partner is deemed to have paid the
premiums with after-tax earnings. Benefits received under such a policy are excludable from the
self-employed person’s income, because the benefits were neither paid nor financed by an
employer.28
If both the employer and the plaintiff-taxpayer contributed the premiums, the source and
amount of the premium contributions must be analyzed. The amounts received under an
accident or health insurance contract that are attributable to the employer contributions are not
excludable from gross income, but the amounts that are attributable to the plaintiff-taxpayer
contributions are excludable from gross income.29 Further, if an employee reimburses his
employer for the premiums paid on his behalf, any disability payments he may subsequently
26
Code Section 104(a)(3); Regs. Section 1.104-1(d). It should be noted, however, that the parenthetical portion
of the statute is applicable for taxable years beginning after 1996.
27
Code Section 105(g); Regs. Section 1.105-5(b).
28
Rev. Rul. 91-26, 1991-1 CB 184; Rev. Rul. 58-90.
29
Regs. Section 1.105-1.
7
receive are fully excludable from his gross income.30 Similar treatment applies to amounts
received under accident or health plans and amounts received from sickness or disability funds.31
The focus is not on the title or description of the insurance under which payments are made. As
such, if an automobile policy pays loss of income payments relating to personal injuries suffered
in an automobile accident, the plaintiff-taxpayer could exclude the payments as amounts
received under accident or health insurance.32 Further, policies or plans that provide only
income replacement payments in the event of disability from injuries or sickness are health and
accident policies.33
Note: The exclusion for employer-financed benefits may, in some instances, be
circumvented under Code Section 105.
3.
WORKMEN’S COMPENSATION ACTS
Amounts received by employees under a workmen’s compensation act or a statute in the
nature of a workmen’s compensation act as a result of personal injuries or sickness incurred in
the course of employment are excluded from gross income.34 The exclusion is limited to the
amount provided in the applicable workmen’s compensation statute. Further, even in situations
where the employee’s retirement is precipitated by an on-the-job injury, the exclusion does not
apply to a retirement pension or annuity paid in that regard to the extent it is determined by
reference to the employee’s age or the employee’s length of service.35 Finally, similar
considerations are relevant when the on-the-job injury resulted in the employee’s death and a
survivor claim is being pursued.
Code Section 104(a)(1) provides that workmen’s compensation received by an employee
(or his survivors) is excludable from gross income only if the compensation is:
a.
(i)
received under a law that qualifies as a workmen’s compensation
act or as a statute in the nature of a workmen’s compensation act;
(ii)
received on account of personal injuries or sickness incurred in the
course of employment; and
(iii)
is not a retirement pension or annuity measured by the employee’s
age, length of service, or prior contributions.
Qualified Law Requirement.
30
G. Bouquett, 67 TCM 2959.
31
Code Section 105(e); Regs. Section 1.105-5.
32
Rev. Rul. 73-155, 1973-1 CB 50.
33
A. Trappey, 34 TC 407.
34
Code Section 104(a)(1).
35
Regs. Section 1.104-1(b).
8
In order for an exclusion under Code Section 104(a)(1) to be allowed, payments received
by an employee (or a survivor) must have been made pursuant to a statute that is a workmen’s
compensation act or in the nature of a workmen’s compensation act.
The term “statute” has been construed liberally to include regulations issued under
statutory authority and a program established pursuant to a statutory authority. 36 It includes an
ordinance or resolution of a municipality or other political subdivision of a state, provided that
the governmental unit is acting within the powers given it by the state.37 It has also been held to
include a regulation adopted by a governmental body pursuant to a state law authorizing it to
provide benefits for employees who are injured in the performance of their duties. 38 There are
numerous state laws which qualify as workers’ compensation acts. Additionally, some important
federal statutes that qualify as workers’ compensation acts are:
(i)
The Federal Employee’s Compensation Act (FECA) (5 U.S.C.
§ 8101 et seq.).39
(ii)
The Longshoremen’s and Harbor Workers’ Compensation Act
(33 U.S.C. Ch. 18).40
(iii)
The Federal Coal Mine Health and Safety Act of 1969 (P.L. 91173, 30 U.S.C. § 801), as amended by the Black Lung Benefits Act
of 1972 (P.L. 92-303).41
(iv)
The Public Safety Officers’ Benefits Act of 1976 (P.L. 94-430).42
The Code Section 104(a)(1) exclusion does not apply to benefits in the following categories: 43
(i)
a retirement pension or annuity to the extent that it is determined
by reference to the employee’s age or length of service, or the
employee’s prior contributions, even though the employee’s
retirement is occasioned by an occupational injury;
(ii)
amounts received as compensation for a nonoccupational injury; or
36
Dyer v. Comr., 71 T.C. 560 (1979).
37
Rev. Rul. 72-291, 1972-1 CB 36.
38
Rev. Rul. 83-91.
39
Rev. Rul. 78-416.
40
Regs. Section 1.104-1(b).
41
Rev. Rul. 72-400, 1972-2 CB 75.
42
Rev. Rul. 77-235.
43
Regs. Section 1.104-1(b).
9
(iii)
amounts received as compensation for an occupational injury to
the extent that they are in excess of the amount provided in the
applicable workers’ compensation act or act or in the nature of a
workmen’s compensation act.
Note: Amounts received under union contracts are not considered received pursuant to a
statute in the nature of a workmen’s compensation act and, hence, do not qualify
for exclusion under Code Section 104(a)(1).
b.
Occupational Injuries Requirement.
A law qualifies as a workmen’s compensation act (or a statute in the nature of workmen’s
compensation) only if, in addition to qualifying as a statute (as discussed above), it provides for
compensation for injuries or illness suffered in the course of employment.44 If the act in question
provides for compensation to employees on account of injuries or illness regardless of whether
such injuries or illness are incurred in the course of employment, such statute does not qualify as
a workmen’s compensation act or a statute in the nature of a workmen’s compensation act for
Code Section 104 purposes.
Note: Assuming that the statute is a workers’ compensation act, if benefits are,
in fact, paid because of occupational disability, it is irrelevant that the
same benefits would have been paid if the employee retired for some
other reason.45
In some instances, a statute may provide benefits for occupational injuries and also
provide other types of benefits, such as retirement benefits based on such factors as age and
years of service. In these instances, the provisions for occupational benefits constitute a
workers’ compensation statute; the other provisions do not.46
Further, if a statute pays disability benefits, but does not distinguish between
occupational and nonoccupational injuries, it does not satisfy the test. It is irrelevant that a
covered injury happens to be occupational; the portion of the statute upon which the plaintifftaxpayer relies must be specifically limited to occupational injuries.
Note: The determination of whether benefits received are for occupational or
nonoccupational injuries is a question of fact, and the plaintiff-taxpayer
has the burden of proof to establish that the benefits in question are for
occupational injuries.
c.
Presumptions as to Nature of Injury.
Statutes (such as a municipal ordinance) containing an irrebuttable presumption that
injuries or illness are work-related create an interesting problem. Both the courts and the Service
44
Id.
45
W.L. Neill, Dec. 18,672 (Acq.).
46
W.R. Frye, 47-2 USTC.
10
have uniformly concluded that such statutes do not qualify as workmen’s compensation acts (or
statutes in the nature of workmen’s compensation acts) because an irrebuttable presumption
permits payment of benefits for injuries or illness that are not work-related. Even if there is an
actual showing that a particular employee’s injuries or illness were work-related, the fact that the
statute in question contains an irrebuttable presumption that would result in payment of benefits
to employees whose injuries were not incurred in the course of employment is controlling. Thus,
if a statute contains an irrebuttable presumption about certain injuries or illnesses, the Code
Section 104(a)(1) exclusion does not apply to compensation received by an employee for such
injuries or illnesses even if it can be shown that the injuries or illnesses actually are workrelated.47
A statute that creates a rebuttable presumption that a disability is work-related may
qualify as a workers’ compensation act.48 However, the presumption does not remove the need
for proof that the disability is work-related. Instead, it shifts the burden of proof of the cause of
disability from the employee to the administrators of the disability pension system.
A statute cannot be classified as a workers’ compensation act if the benefits authorized by
it are voluntary or discretionary. For instance, in a matter in which an ordinance provided an
allotment for each minor child of a policeman or fireman who was receiving disability payments
under another ordinance that was indisputably a workers’ compensation act, the ordinance
essentially stated that the payments were voluntary and could be terminated at any time. Since
the allotments were voluntary (and, thus, inconsistent with a fundamental objective of workers’
compensation laws), they were not payments under a workers’ compensation act.49
In some instances, an employer and employee agree that the employee will assign to the
employer amounts the employee receives in connection with workers’ compensation benefits in
exchange for the employer continuing to pay full wages. In this case, the excess of the wages
over the assigned benefits are includible in the employee’s gross income. The portion that does
not exceed the assigned benefits is excludable as an amount received under a workers’
compensation act.50
d.
Age, Length of Service or Prior Contributions.
If a payment to a plaintiff-taxpayer is a retirement pension or annuity determined by
reference to the person’s age, length of service, or prior contributions, the payment will not
qualify as compensation for work-related injuries or illness. As such, the statute pursuant to
which the payments are made will not be a workmen’s compensation act (or a statute in the
nature of workmen’s compensation act). Therefore, the Code Section 104 exclusion does not
apply to these payments even if the employee’s retirement is caused by an injury or illness
incurred in the course of employment.
47
Green v. Comr., T.C. Memo 1994-264, aff’d, 60 F.3d 142 (2d Cir. 1995).
48
Rev. Rul. 85-105.
49
Rev. Rul. 73-346, 1973-2 CB 24.
50
Rev. Rul. 56-83, 1956-1 CB 79.
11
As noted above, whether the statute qualifies as a statute in the nature of a workmen’s
compensation act is based on whether compensation is paid under the statute for injuries or
illness suffered on-the-job. A plaintiff-taxpayer will not be denied the Code Section 104
exclusion if the compensation she receives is measured by reference to her salary before
retirement.
The fact that disability benefits paid under a workers’ compensation act are equal to the
salary that the plaintiff-taxpayer received at the inception of disability does not prevent exclusion
of those benefits.51 This fact does not override the fact that they were paid because of injuries or
illness arising on-the-job.52
Note: If the plaintiff-taxpayer returns to work, but at a different duty level, and
continues to receive payments, the amount the plaintiff-taxpayer receives
is included in gross income since they were performed in connection with
services rendered.
4.
PAYMENTS RECEIVED AS A PENSION OR ANNUITY FOR PERSONAL
INJURIES SUFFERED BY “MILITARY” PERSONNEL
Special provisions are in place for occupational injuries or sickness suffered by those
serving in the “military”. In this regard, amounts received as a disability annuity payable under
Section 808 of the Foreign Service Act of 1980 are excludable from gross income. Further,
amounts are excluded from gross income if they are received as a pension, annuity, or similar
allowance by persons listed below for personal injuries or sickness resulting from active service
in (i) the armed forces of any country, (ii) the National Oceanic and Atmospheric Administration
(NOAA) (formerly Coast and Geodetic Survey), or (iii) the Public Health Service. These
amounts are excludable by the individual claiming the exclusion if:
(i)
the individual was entitled to receive the amounts on or before
September 24, 1975;
(ii)
on September 24, 1975, the individual was a member (or in a
reserve component thereof) (or had a binding written commitment
to become a member of the listed entities);
(iii)
the individual receives the excludable amounts by reason of a
combat-related injury if the injury was:
(1) incurred:
(a) as a direct result of armed conflict;
(b) while engaged in extra hazardous service; or
51
Rev. Rul. 75-500, 1975-2 CB 44.
52
Rev. Rul. 68-10, 1968-1 CB 50.
12
(c) under conditions simulating war;
or
(2) caused by an instrumentality of war.53
or
(iv)
upon application, the individual would be entitled to receive
disability compensation from the Veterans’ Administration.54
There are certain military disability benefits that may not be excluded from gross income.
For instance, pursuant to 37 U.S.C. § 502, a member of the armed forces who is absent from duty
because of sickness or wounds or who has been ordered from duty pending disability retirement
proceedings is entitled to the same pay and allowances that would be received if there were no
absence. Therefore, the amounts received under this statute are not excludable as military
disability benefits because the statute does not limit payment of these amounts to individuals
with occupational disabilities. The rationale of this result as set forth in R. B. Lonestar, a Tax
Court Memorandum, appears to be based on the fact that 37 U.S.C. § 502 does not distinguish
between occupational and nonoccupational disabilities.55 It should be noted, however, that this
memorandum of the Tax Court has been questioned.56
Under Army regulations, a member of the Army reserve who is injured during his period
of training is entitled to receive continuation pay for up to six months while disabled. This pay is
considered to be salary and is not excludable from income as military disability pay.57 One
would expect that the result would be the same in the case of any similar payment made to
reservists in other branches of the armed forces.
No disability benefit received by an armed forces retiree is excludable from gross income
to the extent that it exceeds a benefit calculated on the basis of the taxpayer’s percentage of
disability. The calculation of the taxpayer’s disability must be determined by military officials
authorized to do so pursuant to 10 U.S.C. § 1403. As such, unless the appropriate military
officials have made a formal determination that the taxpayer has a particular percentage of
disability, no part of her military retirement benefits can ever be excludable from her gross
income.58
53
Code Section 104(b)(3).
54
Code Section 104(b).
55
R.B. Lonestar, 47 TCM 1118, Dec. 41,004 (M), TC Memo. 1984-80.
56
See J.R. Hernandez, 72 TC 1234, Dec 36,363.
57
Id.
58
I. Umfleet, 47 TCM 793, Dec. 40,716(M), TC Memo. 1983-787.
13
5.
DISABILITY PAYMENTS FOR INJURIES SUFFERED IN TERRORIST
ATTACKS
An individual may exclude from gross income amounts received as disability income
attributable to injuries suffered as a direct result of a terroristic or military action. This term
means:
6.
(i)
Any terroristic activity which a preponderance of the evidence
indicates was directed against the United States or any of its allies,
and
(ii)
Any military action involving the U.S. armed forces and resulting
from violence or aggression against the United State or its allies
(or threat thereof.).59
MISCELLANEOUS CONSIDERATIONS
a.
“Wages”.
Once payments received in connection with a settlement or judgment are categorized as
“wages”, they are then subject to employment taxes as well. Back pay paid to an employee or
former employee is “wages” notwithstanding the fact that back pay is frequently awarded for a
period during which no services were performed by the employee. 60 In most cases, dismissal
pay, severance pay, or other payments for involuntary termination of employment are “wages”.
Even though most employment actions result in settlements characterized as “wages”, there are
exceptions. For instance, legally designated interest may be excepted from the definition of
“wages”.61 Further, “liquidated damages” awarded under certain statutes (i.e., Fair Labor
Standards Act, Age Discrimination in Employment Act) are not wages for employment tax
purposes.62 Finally, damages attributable to loss of earning capacity may not be considered
“wages”.63
Note: Another example of when a payment may be considered “wages” and, thus,
employment taxes owed, involves a settlement of an estate where a beneficiary
receives payment for “services rendered” to the decedent.
b.
Unallocated Amounts.
59
Code Sections 104(a)(5); 692(c)(2)
60
Social Security Board v Nierotko, 327 U.S. 358 (1946).
61
Rev. Rul. 80-364, 1980-2 C.B. 294.
62
Rev. Rul. 72-268, 1972-1 C.B. 313.
63
Dotson v. U.S., 87 F.3d 682, 683 (5th Cir. 1996).
14
In many instances, the judgment or settlement amounts received by the plaintifftaxpayer are not allocated between injuries to the person and other claims that do not result in
excludable damages. Similarly, if a claim or suit for personal injuries demands both
compensatory and punitive damages, settlement documents oftentimes do not allocate the award
between the compensatory and the punitive damages. In cases in which excludable and nonexcludable damages are involved, the courts analyze unallocated amounts awarded under a
settlement agreement between the parties and amounts awarded by a judge or jury differently.
When a settlement agreement is involved, whether amounts are excludable from gross
income depends on the nature of the injury which was the actual basis for settlement, not the
validity of the claim.64 Thus, it is imperative to determine the injury suffered by the plaintifftaxpayer that serves as the basis for the award.65 If the settlement agreement does not
specifically state that the payment was made on account of personal injury, then the most
important factor in determining whether the payment is excludable from gross income is the
intent of the payor as to the purpose in making the payment.66 However, the allocation made in a
settlement agreement must be bona fide and at arm’s length. If it is determined that an allocation
to accommodate the plaintiff’s desire for a particular tax result, the Service will not allow that
allocation to control.67 Since oftentimes the interests of the parties to a settlement agreement are
adverse, express allocations are likely to be the result of an arm’s-length and adverse negotiation
process. For example, an amount paid by the payor to settle a lost profits claim is currently
deductible by the defendant-payor but it is ordinary income to the plaintiff-taxpayer. On the
other hand, if the same amount is allocated to a harm to capital assets claim it may constitute
capital gain income to the plaintiff-taxpayer but may not be currently deductible by the
defendant-payor. In cases where the payor is indifferent from a tax standpoint as to how the
amounts are allocated by the recipient in the settlement agreement, Service scrutiny will likely
increase.
When a judgment is involved, if the trier of fact (jury or judge) does not indicate the basis
of the award, the nature of the damages is determined by examining the allegations contained in
the plaintiff-taxpayer’s filed pleadings, the evidence presented at trial, and the arguments made
in the proceeding.68 In most instances, the allocation issue does not arise if a dispute is resolved
through a judgment and the court order specifically allocates the total recovery among the
various claims. However, the Service is less likely to accept the allocation of a settlement award
supervised by a state court where the trial judge fails to conduct an independent review of the
settlement agreement.
c.
Punitive Damages.
64
D.G. Seay, 58 TC 32, Dec. 31,331.
65
W.E. Church, 80 TC 1104, Dec. 40,216.
66
Robinson v. Commissioner, 102 T.C. 116 (1994).
67
E.E. Robinson, CA-5, 95-2 USTC.
68
J.E. Threlkeld, CA-6, 88-1 USTC ¶ 9370, 848 F.2d 81.
15
Code Section 104(a)(2) provides that punitive damages received in personal injury
lawsuits are not excludable from gross income.69 There is a limited exception from the general
rule of Code Section 104(a)(2). Under this exception punitive damages received in a physical
personal injury lawsuit are excludable from gross income only if the following conditions are
satisfied:
(i)
the damages are awarded in a civil action which is a wrongful
death action; and
(ii)
the applicable state law, which is usually that state’s wrongful
death statute (as in effect on September 13, 1995, and without
regard to any modification after such date), provides (or has been
construed by a court in a decision issued on or before September
13, 1995, to provide) that only punitive damages may be awarded
in such an action.
If that state’s wrongful death statute is later held by a court of competent jurisdiction to
allow parties other remedies under the statute or amended to provide for the expansion of
remedies, then this exception no longer applies.
d.
Periodic Payments and Prejudgment Interest.
Damages are often paid in installments. If a recovery is excludable from gross income, it
is immaterial whether the taxpayer receives the payment in one lump sum or in installments
spread over several months or even years.70 In such an event, plaintiff-taxpayer may generally
exclude the installment payments, in full, as they are received. A taxpayer is not required to
ascertain the interest element and include that element in income.71
However, a different result is reached when the payments are explicitly designated as
interest on damages whether by agreement or by statute. Generally such payments are not
excludable from gross income. Likewise, prejudgment interest that is mandated by some state
statutes is not excludable from gross income, regardless of court decisions under state law which
characterize prejudgment interest as an element of damages for certain purposes. 72 Courts have
repeatedly held that such interest was not excludable from gross income under Code Section
104(a)(2). It has been held that prejudgment interest was not excludable from gross income
under Code Section 104(a)(2) because it was not received “on account of” a personal injury but
rather “on account of” lost time value of money.73
IV.
AMOUNTS RECEIVED IN NON-PERSONAL INJURY CASES
69
Code Section 104(a)(2).
70
Code section 104(a)(2).
71
Rev. Rul. 79-220, 1979-2 CB 74.
72
M. Brabson, CA-10, 96-1 USTC.
73
Brabson v. U.S., 73 F.3d 1040 (10th Cir. 1996).
16
There is no special provision providing an exclusion from gross income of amounts
received pursuant to judgment or a settlement in cases where the plaintiff-taxpayer’s lawsuit
asserts a non-personal injury. To the contrary, such amounts are includible in gross income
under Code Section 61 which requires that “all income from whatever source derived” be
included in gross income.74 The only situations where payments received in non-personal injury
cases are excludable from gross income are those instances where such payments are a substitute
for amounts which are excludable from gross income under a specific statutory provision (e.g.,
gifts or inheritances).
Example:
1.
Prior to his death, Father promised Son that he would leave him
60% of his estate. Upon Father’s death, a review of the Father’s
will indicated that Father had left equal shares to his sole
survivors, Son and Daughter. Son brought suit claiming that he
was entitled to a larger share of the estate. Son received a lump
sum in settlement of the suit. The lump sum is excludable from
gross income as a payment received in lieu of a bequest.75
ORDINARY INCOME OR CAPITAL GAIN
In “business injury” cases, the issue is generally whether amounts received pursuant to a
judgment or settlement are characterized as ordinary income, return of capital or capital gain. As
with the analysis involving payments made in connection with personal injury claims, the focus
is on the nature of the underlying claim. If, upon examining the nature of the underlying claim,
it is determined that the recovery is a substitute for lost profits, then such amounts are includible
as ordinary income. On the other hand, if the recovery is intended to compensate the plaintifftaxpayer for loss of goodwill or harm to other capital assets, then the amounts are characterized
as capital gain (provided the sale or exchange requirement of Code Section 1221 is met). In
cases where the plaintiff-taxpayer is being compensated for several types of losses (i.e. lost
profits and loss of goodwill), an allocation between ordinary income and capital gain may be
required.
Generally, a recovery solely for harm to capital assets results in capital gain or a
reduction of capital loss depending upon the plaintiff-taxpayer’s basis in the capital asset
(provided the sale or exchange requirement of Code Section 1221 is met).76 However, the
plaintiff-taxpayer’s recovery may still be subject to ordinary income recapture.
Example:
Owner received $200,000 as a payment for damage done to Owner’s
building. With respect to the building, Owner had an adjusted basis of
$100,000 and accumulated depreciation of $50,000. Owner would have
ordinary income recapture of $50,000 and capital gain of $50,000.
74
Regs. Section 1.61-14(a).
75
Getty v. Comr., 913 F.2d 1486 (9th Cir. 1990), rev’g 91 T.C. 160 (1988).
76
Rev. Rul. 74-251, 1974-1 C.B. 234.
17
As noted above, if the recovery may be intended to compensate the plaintiff-taxpayer for
both lost profits and harm to capital assets, the taxpayer is required to allocate (and prove) the
amounts received to lost profits (i.e., ordinary income) and damage to capital assets (i.e., capital
gains).77
V.
DEDUCTION OF PAYMENTS BY THE PAYOR
Although there are fewer issues involved when a payor makes a payment in connection
with a settlement or judgment, various items dictate how the payor can treat the payment.
Payments made by a payor pursuant to a judgment or settlement may be deductible either as a
business expense under Code Section 162 or as production of income expense under Code
Section 212.
1.
BUSINESS EXPENSES
If the payor is engaged in a “trade or business,” provided the requirements of Code
Section 162 are met, any payments made pursuant to a judgment or a settlement in connection
with such trade or business are deductible.78
If the payor is engaged in a trade or business, the issue that arises most frequently is
whether the payments (i) are deductible currently, or (ii) should be capitalized. Similar to the
analysis of the plaintiff-taxpayer’s position, in order to resolve this issue the origin and the nature
of the claim against the payor is examined (rather than the potential consequences to the payor).
If the allegations against the payor include more than one claim and the payment is intended to
satisfy more than one claim, the payment must be allocated among various claims. A payment
made to satisfy a claim, that would be includible in income by the recipient as ordinary income
(such as lost profits), would generally be deductible by the payor currently under Code Section
162. On the other hand, a payment includible by the recipient as capital gain (such as an amount
paid to satisfy the recipient’s claim arising out of the transfer of a capital asset to payor) would
generally be required to be capitalized by the payor.
2.
PRODUCTION OF INCOME EXPENSE DEDUCTION UNDER CODE
SECTION 212
Even if the payor’s activities do not arise to the level of a “trade or business”, provided
other requirements for the deductibility as a trade or business expense are met, payments made
pursuant to a judgment or a settlement may still be deducted.79 In order to satisfy Code Section
212, the sole requirement is that the payments are made pursuant to an activity that constitutes an
income-producing activity. Similar to trade or business expenses under Code Section 162, an
important consideration with respect to production of income expenses is whether such expenses
are currently deductible or should be capitalized. Once again, the nature of the plaintiff’s claim
77
Collins v Comr., 18 T.C.M. 756 (1959).
78
Code Section 162(f).
79
Code Section 212. However, it should be noted that a Code Section 212 deduction is not available to
corporations and partnerships.
18
must be analyzed. For instance, a payment made to settle the plaintiff’s claim for specific
performance of a contract to sell stock must be capitalized because it relates to the sale or nature
of exchange of a capital asset.80 If the nature of the underlying claim does not relate to harm to a
capital asset, a payment made pursuant to such a claim is currently deductible.81
3.
FINES AND PENALTIES
No deduction is allowed for any “fine or similar penalty” paid to a “government” for a
violation of any law.82 The term “fine or similar penalty” includes civil and criminal penalties
for the violation of any law, payments in settlement of actual or potential civil or criminal
liabilities, as well as, payments made pursuant to a guilty or a no-contest plea.83 The term
“government” includes federal, state, or foreign government or similar entities or
instrumentalities of such government.84 A distinction is made between payments that are
remedial in nature (for which a deduction may be allowed) and payments that are penal or
punitive in nature for which a deduction is disallowed.85
VI.
LEGAL FEES
Although not specifically permitted in the Code, legal fees86 (whether or not they are
incurred in connection with actual litigation) may be deductible as business expenses under Code
Section 162 or as production of income expenses under Code Section 212. The tests are
substantially the same as those for business expenses generally. For example, they prevent a
current deduction for a legal expense incurred in the acquisition of goodwill or another capital
asset. In these cases, legal fees may not be deductible currently and may be required to be
capitalized. For instance, the payor (as well as the recipient) of an amount pursuant to a
judgment or a settlement may deduct under Code Section 162 legal fees incurred in the litigation
provided the litigation relates to a trade or business conducted by the taxpayer and the legal fees
are ordinary and necessary expenses and reasonable in amount. If the taxpayer is not engaged in
a trade or business, legal fees may still be deductible under Code Section 212 if the taxpayer is
engaged in activities for the production of income or the management, conservation, or
maintenance of income-producing property. If the dispute with respect to which the legal fees
are incurred relates to a capital asset, the legal fees must be capitalized. In either instance,
80
Fischer v. U.S., 490 F.2d 218 (7th Cir. 1974), aff’g 336 F. Supp. 428 (D. Wisc. 1972).
81
PLR 9039023.
82
Code Section 162(f).
83
Regs. Section 1.162-21(b)(1).
84
Regs. Section 1.162-21(a).
85
TAM 8704003 (payments made in settlement of allegations of violations of the Anti-Dumping Act of 1921
were deductible due to the remedial nature of the Act).
86
For purposes of this discussion, expenses other than legal fees such as court costs, expert fees, etc., incurred in
connection with the prosecution or defense of legal remedies will be grouped into “legal fees.”
19
success or failure of the taxpayer in establishing its contention usually does not affect
deductibility.
Note: Although legal fees are the principal concern of actions involving
deductions for “legal” expenses, other expenses, such as those incurred in
connection with accountants, witnesses, or other persons involved in the
preparation and presentation of the defense or otherwise supporting the
taxpayer’s position, may be deductible.
In order to determine whether legal fees are deductible under Code Section 162 (or Code
Section 212) or whether such fees must be capitalized, the origin and the nature of the claim test
is applied. Under the doctrine, the origin and character of the claim, rather than the potential
consequences to the taxpayer, are determinative.87
Generally, the legal fees paid in connection with defending a claim follow the same
character as the payment made (or the recovery). For instance, from the payor’s viewpoint, if a
payment pursuant to judgment or a settlement is required to be capitalized, legal fees incurred in
the litigation would also be required to be capitalized.88 Likewise if a payment is deductible
currently, legal fees may also be currently deductible. If the lawsuit is unsuccessful and there is
no recovery, legal fees may still be currently deductible or required to be capitalized depending
upon the origin of the claim pursued. Legal fees would be required to be capitalized, for
example, if the lawsuit related to the preservation or purchase of a capital asset. The same
analysis applies to legal fees incurred by the recipient of any settlement or judgment amount or
purchase of a capital asset regardless of the outcome.
If the recovery is required to be allocated to more than one claim, legal fees must be
apportioned among various claims ratably and the amount apportioned to a particular claim will
follow the character of the recovery for such claim. For example, if a recovery is allocated to
claims for lost profits and damage to a capital asset, legal fees apportioned to the lost profits are
currently deductible but the amount apportioned to the capital asset claim must be capitalized.
1.
CONTINGENT FEE ARRANGEMENTS
a.
History.
There was a conflict among the circuit courts as to whether an attorney’s contingency fee
should be included in the client’s income under Code Section 61, even though the attorney
received and paid taxes on all of the contingent fee payment and the client did not receive the
money directly. This issue plagued courts, the Service, and taxpayers since the earliest days of
the federal income tax. The problem essentially involves the definition of gross income and
judicial rules governing the assignment of income. Under normal circumstances, established tax
rules requires the plaintiff-taxpayer to include the entire amount of the taxable award, including
the portion used to pay relevant attorneys’ fees and litigation expenses, in gross income and then
deduct the fees and expenses under one of several methods (discussed below). However, when
87
D. Gilmore, S. Ct. 63-1 USTC.
88
American Dispenser Co., Inc. v. Comr., 396 F.2d 137 (2d Cir. 1968), aff’g T.C. Memo 1967-153.
20
certain state’s (such as Alabama) attorney’s charging lien is considered, the normal, expected
result was altered.
The debate about whether the portion of a taxable damage award attributable to
contingency-based attorneys’ fees should be excluded from gross income of the plaintifftaxpayer would be moot if all taxpayers were allowed to deduct the entirety of the fees and
expenses. Conversely, the question is equally moot in cases where the damage award is
excluded from gross income by Code Section 104 because deductions are not allowed for any
expense allocable to a nontaxable class of income.89
Plaintiff-taxpayers who receive taxable damage awards subject to contingency-based
attorneys’ fees and expenses essentially have two basic opportunities to deduct expenses.90 First,
they can attempt to deduct the litigation expenses under Code Section 162(a) as a trade or
business expense.91 Since these are “above-the-line” deductions, this approach would allow an
undiluted reduction of taxable income. Many individual plaintiffs, however, do not sue in a
business capacity and will not be able to meet Code Section 162(a)’s requirements that expenses
be ordinary and necessary expenses incurred in the conduct of a trade or business.
Most individual plaintiff-taxpayers, therefore, will be forced to pursue the second option
and deduct the expenses as a miscellaneous itemized deduction. Normally, Code Section 262(a)
denies deductions for personal, living and family expenses.92 Contingency-based attorneys’ fees
that are not deductible elsewhere can often be deducted as a miscellaneous itemized deduction
“for the production of income” under Code Section 212.93 The regulations require that such a
deduction be reasonable in amount and bear proximate relation to the production of income.94
The miscellaneous itemized deduction treatment of litigation expenses creates several
problems for plaintiff-taxpayers who receive large taxable damage awards. Miscellaneous
itemized deductions are only allowed to the extent that they exceed two percent of adjusted gross
income (“AGI”).95 The Code also imposes a phaseout of itemized deductions for taxpayers with
an AGI over certain thresholds. The final and most insurmountable obstacle posed by
miscellaneous itemized deduction treatment is the alternative minimum tax (“AMT”). This is
because of the AMT’s disallowance of miscellaneous itemized deductions.96 If a plaintiff89
Code Section 265(a)(1) (1994).
90
It should be noted that a third approach requires taxpayers to capitalize litigation expenses under Code Section
263.
91
Code Section 162(a).
92
Code Section 262(a).
93
Code Section 212.
94
Regs. Section 1.212-1(d) (as amended in 1975).
95
Code Section 67(a).
96
Code Section 56(b)(1)(A)(i).
21
taxpayer’s award is large enough to trigger AMT treatment, the taxpayer will lose the benefit of
deducting the attorney’s fees as a miscellaneous itemized deduction.97 In other words, a
miscellaneous itemized deduction for contingency-based attorneys’ fees in the context of a large
taxable damage award is something that the plaintiff-taxpayer never realizes.
b.
Banks/Banaitis.
In an effort to alleviate the uncertainty caused by the divergence of opinions rendered by
the various circuit courts, on January 24, 2005, the United States Supreme Court decided
Commissioner v. Banks and Commissioner v. Banaitis98. In both cases, the Supreme Court
concluded that the clients must include in their income the portion of the litigation recovery paid
to their attorneys. The Court reasoned that the suit essentially belonged to the client since, in
part, the client controlled all important aspects of the suit (i.e., deciding if and when to settle the
suit and on what terms). As an analogy, the Court compared the relationship between an
attorney and client to that of a commissioned salesman. In explaining its decision, the Court
noted that the attorney is merely an agent for the client and not its business partner. The Court
then used established principles of income taxation to come to the conclusion that the taxpayer is
prohibited from excluding income derived from her property through an anticipatory assignment
of that income. In that regard, the Court stated:
We hold that, as a general rule, when a litigant's recovery constitutes income,
the litigant's income includes the portion of the recovery paid to the attorney as a
contingent fee.
Since the Court's holding suggested it was a general rule, one would think that the Court
was envisioning that there would be exceptions to follow. Although the Court's decision does
talk about the impact of the various states' laws regarding an attorney's interest in the suit (which
was the basis of earlier holdings in favor of the taxpayer), the opinion was not overwhelmingly
clear that it meant to foreclose the argument that a state's laws was relevant to the determination.
The exceptions that the Court may have been envisioning when it wrote its opinion could have
derived from amicus briefs filed in connection with the suits. The Court referred to "novel
propositions," stating that those arguments were being presented for the first time to the Court
and had not been a part of the earlier court proceedings. While the Court declined to comment
materially on those propositions, it did detail the propositions as follows:
(i)
a contingent fee agreement between the attorney and the client
established a Subchapter K partnership between the two;
(ii)
all of the recovery in the suit constitute proceeds from the
disposition of property and, as such, attorney's fees must be
subtracted as a capital expense from the proceeds; and
(iii)
all attorney's fees are deductible reimbursed employee business
expenses.
97
Benci-Woodward v. Commissioner, 76 T.C.M. (CCH) 787, 790 (1998).
98
Comr. v. Banks and Comr. v. Banaitis, 543 U.S. 426, 125 S. Ct. 826 (2005).
22
Furthermore, the Court suggested that the result may have been different had the
taxpayer's fee arrangement been different. In particular, had the taxpayer been entitled to (and
requested) statutory attorney's fees, then an argument could have been made that the taxpayer
was not paying the attorney's fees. Instead, the argument could have been made that, pursuant to
the statute, the court had shifted the obligation to pay the fee from the taxpayer to the opposing
party and the opposing party was paying the fee directly to the taxpayer's attorney.
Practice Pointer:
As a practical matter, in order to present the case as favorably for the
taxpayer as possible, planners should consider the following:
(i)
if there is a basis for a statutory award of attorney's fees, then the
settlement agreement or judgment should reference the statute and
specifically allocate what portion of the entire amount being paid
as attorney's fees is being paid pursuant to that statute.
(ii)
the fee agreement between the attorney and client should state that
any award of fees to the taxpayer's attorney is in lieu and full
satisfaction of all statutory fees to which the attorney may be
entitled to receive; and
(iii)
careful attention should be paid to the drafting of any settlement
agreement so as to address the items that the taxpayer may need to
later argue in connection with a dispute with the Service.
c.
American Jobs Creation Act of 2004:
The American Jobs Creation Act of 200499 ("AJCA") allowed an above-the-line
deduction for amounts attributable to attorney’s fees and costs received in connection with
claims of unlawful discrimination or certain claims against the government, including claims
brought under the False Claims Act. Although the Code provides a long laundry list of laws to
which the AJCA applies, the specifically enumerated laws are as follows:
99
(i)
Section 302 of the Civil Rights Act of 1991;
(ii)
Sections 201 through 207 of the Congressional Accountability Act
of 1995;
(iii)
the National Labor Relations Act;
(iv)
the Fair Labor Standards Act of 1938;
(v)
Sections 4 and 15 of the Age Discrimination in Employment Act
of 1967;
(vi)
Sections 501 and 504 of the Rehabilitation Act of 1973;
The American Jobs Creation Act of 2004 (2004 AJCA) P.L. 108-357).
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(vii)
Section 510 of the Employee Retirement Income Security Act of
1974;
(viii)
Title IX of the Education Amendments of 1972;
(ix)
the Employee Polygraph Protection Act of 1988;
(x)
The Worker Adjustment and Retraining Notification Act;
(xi)
Section 105 of the Family and Medical Leave Act of 1993;
(xii)
Chapter 43 of Title 38, United States Code (relating to
employment rights of uniformed service personnel);
(xiii) Sections 703, 704 and 717 of the Civil Rights Act of 1964;
(xiv)
Sections 804, 805, 806, 808 and 818 of the Fair Housing Act;
(xv)
Sections 102, 202, 302 or 503 of the Americans with Disabilities
Act of 1990;
(xvi)
Provisions of federal law (i.e. Whistleblower Protection
provisions) that prohibit the discharge of or adverse retaliation or
reprisal against an employee for asserting rights or taking actions
permitted under federal law; and
(xvii) Any provision of federal, state or local law, or common law claims
that provides for the enforcement of civil rights or regulates any
aspect of the employment relationship, including claims for wages,
compensation or benefits, or prohibiting the discharge of an
employee, discrimination against an employee, or any other form
of retaliation or reprisal against an employee for asserting rights or
taking other actions permitted by law.
The AJCA provides tax relief for attorney's fees only on a prospective basis. In that
regard, it only applies to fees and costs paid after the date of its enactment (October 22, 2004),
with respect to any judgment or settlement occurring after such date.
Note:
In Banks, the Court noted that under the AJCA the taxpayers would not have
obtained the same result had the AJCA been retroactive.
Notwithstanding the AJCA, it would seem that many questions still exist and problems
are sure to follow. For instance, most cases contain more than one allegation of wrongdoing. As
such, in the event the taxpayer alleges numerous causes of action, some of which are under the
umbrella of the AJCA and some of which are not, it would seem to be daunting task to segregate
the attorney's fees incurred in connection with each of the alleged causes of action.
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VII.
CONSISTENCY IN TAX REPORTING CLAUSES
Consistency in tax reporting clauses is part of many settlement agreements. Their basic
purpose is to require all parties involved in the settlement to report the settlement to the Service
in an identical manner. Few miscues get the Service moving more quickly than inconsistent
reporting.
Consistency in tax reporting clauses are often accompanied by tax indemnity clauses.
Tax indemnity clauses essentially punish the breaching party for reporting the settlement in a
manner inconsistent with their agreement. Generally, they provide that if the first party has to
pay additional taxes as a result of the second party engaging in prohibited conduct, the second
party will have to pay the extra amount (plus interest, penalties and attorney’s fees). Tax
indemnity clauses may make it less likely that the other party will breach the consistency in tax
reporting provision, though they may not prevent inconsistent reporting. However, it should be
noted that the Service has contended that, because settlement documents contain a consistencyin-tax-reporting clause and a tax indemnity provision, the negotiations between the parties were
not at arm’s-length.100 The Tax Court, however, held that these provisions did not alter or
impede the arm’s-length nature of the negotiations between the parties.
100
Polone v. Commissioner, T.C. Memo 2003-339.
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