Practical Tips to Serving
as Tax Counsel in Lawsuit
Settlements & Judgments
May 24, 2009
Jared D. Mobley
K&L Gates LLP
Charlotte, North Carolina
Jared D. Mobley
Summary of Presentation
1) Tax Treatment of Payee’s Recovery Payments
2) Taxation of Payee’s Attorney Fees
3) Tax Treatment of Payor’s Expenditures, including
Attorney Fees
4) Key Principles
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1) Tax Treatment of Payee’s Recovery
Payments
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Tax Treatment of Payee’s Recovery Payments
Characterizing a Recovery
Payment for Tax Purposes
General Rule
Origin of the Claim Doctrine:
The federal income tax
characterization of a settlement or judgment payment will be
determined by reference to the origin and nature to which the
claim relates. See, e.g., United States v. Gilmore, 372 U.S. 39
(1963) and Anchor Coupling Co. v. United States, 427 F.2d 429
(7th Cir. 1970). One may ask, “in lieu of what was the settlement
or judgment paid?”
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Tax Treatment of Payees Recovery Payments
Characterizing A Recovery
Payment For Tax Purposes
•
Taxable
•
Non-taxable
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Tax Treatment of Payee’s Recovery Payments
Taxable Payments
• Ordinary Income (maximum federal tax rate of 35%)
• Compensation (subject to ordinary income tax rates,
plus income tax withholding and employment taxes)
• Capital Gain (current maximum federal tax rate of 15%
for individuals, estates & trusts)
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Tax Treatment of Payee’s Recovery Payments
Wages
• Income tax withholding required
• Employment Tax: Social Security Tax (6.2%, 2009 cap
of $106,800)
• Employment Tax: Medicare Tax (1.45%, no cap)
• Employer and Employee each pay an equal share of
employment taxes
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Practice Point #1
NC Special Deduction for Severance
• N.C. Gen. Stat. §105-134.6(b)(11) -- $35,000 state
income tax deduction for severance wages
• Must be permanent and involuntary termination due to
no fault of employee
• No N.C. income tax withholding required for qualifying
severance wages
• Refer to Directive PD - 98-1
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Practice Point #2
Non-Wage Claims in “Employment” Lawsuits
• Certain damages paid in employment lawsuit, although
taxable, may not be “wages” such as:
•
•
Emotional distress and tort-like recoveries.
Interest and legal fees under fee-shifting statutes.
See Rev. Rul. 80-364 and TAM 2002-44-004.
• When representing the employer, be extremely careful
given withholding and remittance obligations and
responsible person liability. The ultimate tax burden
often fall on the employer.
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Tax Treatment of Payee’s Recovery Payments
Non-Taxable Payments
• Damages (other than Punitive Damages) Received “On
Account of Personal Physical Injuries or Physical
Sickness.” IRC §104(a)(2).
• Recoveries Relating to Return of Capital or Basis. See
PLR 2005-13-011 (recovery for faulty construction of
residence).
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2) Taxation of Payee’s Attorney Fees
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Tax Treatment of Payee’s Attorney Fees
GENERAL RULE
• The tax treatment of legal fees paid by the parties in a
settlement or judgment generally is determined by
reference to the nature and tax characterization of the
settlement or judgment payment.
• Where the settlement or judgment payment is allocated
among more than one legal claim, the tax treatment of
legal fees should be proportionately allocated in the
same manner.
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Tax Treatment of Payee’s Attorney Fees
Example 1: Individual Tort Recovery
• Macon receives $100,000 in a lawsuit, and the parties
properly characterize ½ of the payment as received “on
account of physical injuries” and ½ of the payment as
wages. If Macon pays $30,000 of legal fees, then
$15,000 of them would not be deductible or subject to
capitalization (the portion allocable to the tax-free
recovery) and $15,000 would be deductible (the portion
allocable to wages).
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Tax Treatment of Payee’s Attorney Fees
Example 2: Employment Recovery
Macon recovers $360,000 in settlement of an employment
discrimination lawsuit against her employer. Macon owes
her lawyer, $160,000 for legal fees, expenses and costs
associated with the lawsuit.
What is Macon’s federal income tax liability (assuming no
other income or deductions)?
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Tax Treatment of Payee’s Attorney Fees
Macon’s Expectation – Legal Fees Deductible
Gross Income
Legal Fees Deduction
$360,000
- 160,000
$200,000
$200,000
Effective Tax Rate
After-Tax Amount
x
45%
$ 90,000 (IRS)
$110,000 (Macon)
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Tax Treatment of Payee’s Attorney Fees
IRS Expectation - Misc. Itemized Deduction
The $160,000 of attorney fees is a “miscellaneous itemized
deduction” under IRC §68. As such, it is subject to 3
limitations: (i) deductible only to extent it exceeds 2% of
AGI, (ii) Pease limitation (subject to special rules in 2009
and 2010), deduction reduced in an amount equal to the
lesser of (a) 3% of the excess of AGI over an inflationadjusted amount & (b) 80% of certain itemized
deductions), and (iii) AMT Disallowance. As a result,
attorney fees deduction is disallowed, effectively.
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Tax Treatment of Payee’s Attorney Fees
IRS Expectation – Misc. Itemized Deduction
Gross Income
$360,000
Legal Fees Deduction 0
$360,000
$360,000
Effective AMT Rate x
$ 108,000
After-Tax Amount
$92,000
(Attorney Fees)
30%
(IRS)
(Macon)
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Tax Treatment of Payee’s Attorney Fees
Summary of Net Recovery Proceeds
Macon’s Expectation
IRS Expectation
Recovery
$360,000
$360,000
Attorney Fees
- 160,000
- 160,000
Tax Liability
- 90,000
- 108,000
$110,000
$92,000
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Tax Treatment of Payee’s Attorney Fees
Macon’s Position
• Bona Fide Transfer of Rights to Lawsuit Recovery to
Attorney
• Joint Venture or Partnership Between Client and Attorney
• Attorney has Ownership in Lawsuit (via certain state’s
attorney-lien statute)
IRS Position
• Assignment of Income Doctrine (Lucas v. Earl, fruit vs.
tree)
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Tax Treatment of Payee’s Attorney Fees
U.S. Supreme Court Decision
Banks/Banaitis 543 U.S. 426 (2005)
• IRS Wins
• Assignment of Income Doctrine Applies
• Key Ruling: Attorney-Client Relationship is a PrincipalAgent Relationship
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Tax Treatment of Payee’s Attorney Fees
American Jobs Creation Act of 2004
• Partial Legislative Fix (IRC § 62(a)(20)): Above-the-Line
Deduction Allowed for Certain Employment-Related
Claims (effectively removes miscellaneous itemized
deduction and AMT problem for certain claims).
• Applies to “Unlawful Discrimination” Claims. IRC §61(e).
• Applies to Amounts Paid after October 22, 2004 “With
Respect to any Judgment or Settlement Occurring after
Such Date.”
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Tax Treatment of Payee’s Attorney Fees
Claims Falling Outside AJCA of 2004
•
•
•
•
•
•
•
•
•
•
Defamation
Conversion
Breach of Fiduciary Duty
Libel
Invasion of Privacy
Condemnation
Interest?
Punitive Damages?
Denial of Coverage
Tortuous Interference
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Practice Point #3
IRC § 61(e)
• The IRS and Courts have not provided guidance on the
scope of “unlawful discrimination” and the above the line
deduction under IRC § 62(a)(20).
• If representing the payee, will the payee have a better,
after-tax and after-attorney fee payment position if the
full damage award is “wages” instead of emotional
distress or other taxable, non-wage categories?
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3) Tax Treatment of Payor’s Expenditures,
including Attorney Fees
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Tax Treatment of Payor’s Expenditures
GENERAL RULE
• The tax treatment of expenditures paid by the payor in a
settlement or judgment generally is determined by
reference to the underlying nature of the claims related
to the settlement or judgment (again, the origin of the
claim doctrine).
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Tax Treatment of Payor’s Expenditures
Characterizing Expenditures
For Tax Purposes
• Deductible expense
• Capital expenditure
• Non-deductible, non-capital expenditure
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Tax Treatment of Payor’s Expenditures
Deductible Expenses
• Expenses incurred in payor’s trade or business,
including punitive damages (IRC § 162)
• Expenses incurred in a transaction entered into for profit
(IRC § 212)
• Individuals subject to miscellaneous itemized deduction
and AMT limitations for IRC § 212 expenses
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Tax Treatment of Payor’s Expenditures
Capital Expenditures (IRC § 263)
• Expenses for “defending or perfecting title to property”
• Expenses that “add to the value, or substantially prolong
the useful life, of property”
• Expenses attributable to the purchase or sale of a
capital asset
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Tax Treatment of Payee’s Expenditures
Non-Capitalizable, Non-Deductible
Expenditures for Tax Purposes
• No deduction is allowed for personal expenses.
• No deduction is allowed for any fine or similar penalty
paid to a government for the violation of any law. IRC
§162(f).
• No deduction is allowed for payments relating to illegal
kickbacks, illegal bribes or other illegal payments. IRC
§162(c).
• No deduction is allowed for 2/3 of payments made as a
result of violations of certain antitrust laws.
IRC
§162(g).
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Practice Point #4
IRC § 162(f) Fines
• Restitution Payments Outside of IRC § 162(f).
• Compensation Payments Likely Outside of IRC § 162(f).
• Government officials are not coordinating government
settlements with IRS.
• Sen. Grassley is scrutinizing these transactions.
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Practice Point #5
Tax Reporting
• Wages – Report on IRS Form W-2.
• Taxable Non-wages – Report on IRS Form 1099-MISC.
• Non-Taxable - No Reporting required.
• Payment of Legal Fees - Report on Form 1099-MISC.
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4) Key Principles
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Key Principles
Best Evidence Available
The tax treatment of a payment of a settlement or
judgment must be allocated using the “best evidence
available.”
The determination of the best evidence
available requires an analysis of the facts and
circumstances relating to the dispute. For example, the
best evidence available for a pre-trial settlement likely will
be the complaint because it will often be the only document
describing the claim (or claims).
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Practice Point #6
Pre-Judgment Settlements
• Allocations should not be made to claims in the
complaint that are not likely to be successful (“throw-in
claims”) if the case would have gone to full trial and
judgment.
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Key Principles
Burden of Proof
The payee of a settlement or judgment bears the
burden of proving that the payment (or portion
thereof) is a taxable or non-taxable payment. The
payor of a settlement or judgment has a similar
burden of proof.
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Practice Point #7
Shareholder Lawsuits
• If cases where the entity and its key equity holder(s)
both are named in the lawsuit, one must determine
whether the payment is for the benefit of (i) the entity or
(ii) the equity holder (or a combination thereof).
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Key Principles
IRS Review of Recovery Payment
The courts and Internal Revenue Service will generally
respect the allocations in a settlement agreement provided
that such settlement is entered into in an adversarial
context, at arm’s length and in good faith.
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Practice Point #8
Non-Arms Length
• If the parties are not sufficiently “tax adverse” as to a
portion of a recovery, make allocations to that portion
very carefully.
• For example, allocation to non-wage, damage claims
economically benefit both the employer and employee
(due to employment tax savings).
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Key Principles
Failure to Characterize Recovery Payments
The IRS and courts do not give much deference to the tax
characterization of a settlement or judgment payment if the
characterization is made after the resolution of the non-tax
issues of the lawsuit.
The parties must address the tax consequences of a settlement
or judgment payment at some point. If the parties fail to address
them at the time that the non-tax issues are resolved, then their
tax return preparers will have to address the tax consequences
when the applicable tax returns are filed for the year of the
payment or tax reporting is made (e.g., Form 1099, Form W-2)
for such year.
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Key Principles
Settlement and Judgment Tax Provisions
The language in a settlement agreement or judgment will
often have a substantial effect on the tax treatment of
payments made thereunder.
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Key Principles
Settlement and Judgment with Multiple Claims
In a lawsuit with multiple claims, the origin and nature of
each claim must be determined and spelled out in the
settlement or judgment.
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Key Principles
Frequency of IRS Audits
The IRS has been most diligent in its scrutiny of the tax
characterization of settlements and judgments. In 2001,
the IRS released a Market Segment Specialization
Program training guide covering lawsuit awards and
settlements to train their auditors on the issues.
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Practice Point #9
The Authoritative Guide
Robert W. Wood, Taxation of Damage Awards and
Settlement Payments (3d ed, 2004 with 2008 supplement).
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IRS CIRCULAR 230 NOTICE:
In order to comply with certain IRS regulations
regarding tax advice, we inform you that, unless
expressly stated otherwise, any tax advice contained
in this communication (including any enclosures) is
not intended or written to be used, and cannot be
used, for purposes of (i) avoiding penalties under the
Internal Revenue Code or (ii) promoting, marketing or
recommending to another party any transaction or
matter addressed herein.
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