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:: Lawsuit Awards and Settlements
Table of Contents
Introduction
Note:
Because a business entity cannot suffer
a personal injury within the meaning of
IRC section 104(a)(2), P & X Markets,
Inc. v. Commissioner, 106 T.C. 441
(1996), aff'd in unpublished order, (9th
Cir., Feb. 13, 1988), this guide applies
to recoveries by individuals only.
The information and
techniques presented in this guide for
lawsuit settlement examinations were
developed during a project in Alabama, which
began with media coverage of relevant tax
issues. Analyses of newspaper articles
revealed that numerous lawsuits were being
resolved in the state either by verdict or
settlement for substantial amounts. As a
result, a separate project relating only to
lawsuit verdicts and settlements was
initiated and approved.
Early results of the
project revealed that the vast majority of
these lawsuit verdicts and settlements were
escaping taxation. Virtually none of the
payments were reported on Forms 1099. For
this reason, it has been easy for these
payments to fall through the gap of
unreported income.
In the examination of 1994
and 1995 returns, it was often found that
the taxpayer had classified all or most of
the settlement as "compensatory," usually
for "personal injuries," and therefore
arrived at the determination that the
proceeds were nontaxable. This pattern was
found to be repeated in virtually all of the
lawsuit cases, regardless of whether the
claims were for fraudulent actions,
defamation of character, employment related
disputes, product liability, negligence,
wrongful death, etc., and also regardless of
whether or not claims for punitive damages
were involved in the cases.
On the surface, the issue
seems quite simple: Internal Revenue Code
(IRC) section 61 states that all income from
whatever source derived is taxable, unless
specifically excluded by another Code
section. In certain situations an amount of
a lawsuit settlement might be paid to
reimburse a taxpayer for losses, and no gain
would have to be recognized under IRC
section 1001 because the amount paid did not
exceed the taxpayer's basis (return of
capital). However, the only provision which
specifically addresses income exclusions for
any type of lawsuit proceeds is IRC section
104(a)(2). Prior to its amendment in 1996,
this section excluded from income amounts
paid by suit or agreement for personal
injuries or sickness. This is the section
which taxpayers have most often relied upon
for authority to exclude from income lawsuit
proceeds of all kinds, including punitive
damages. This is where the appearance of a
simple issue dissolves.
IRC section 104(a)(2) has
been extensively litigated. The questions
have centered on determining "what are
personal injuries" for purposes of IRC
section 104(a)(2). The issues have
encompassed physical versus non-physical
(mental anguish) injuries and sickness, and
whether punitive damages are received on
account of personal injuries. In 1989,
Congress amended IRC section 104(a)(2)
referencing punitive damages and
non-physical injuries. However, due to the
manner in which the statement was worded,
the 1989 amendment only created more
controversy. The Service's current position
is that punitive damages are not received on
account of personal injuries under IRC
section 104(a)(2), and therefore are not
excludable from gross income. In 1996, on
the heels of several court decisions that
had upheld the Service's position, Congress
resolved the controversy and amended IRC
section 104(a)(2). The 1996 changes clearly
provide that punitive damages are not
excludable under IRC section 104(a)(2),
regardless of whether received in connection
with a physical or non-physical injury or
sickness. However, the 1996 amendment to IRC
section 104(a)(2) has raised the issue
whether punitive damages received in
connection with a wrongful death are
excludable from gross income. This question
is discussed in detail in a subsequent
section.
The 1996 changes further
provide that amounts excludable for
emotional distress are limited to actual
"out of pocket" medical costs in cases of
non-physical injuries, such as
discrimination, fraud, etc. However, all
amounts received on account of a physical
injury, with the exception of punitive
damages, are excludable under IRC section
104(a)(2), including amounts for emotional
distress. These clarifying and limiting
changes to the statute are effective for
amounts received after August 20, 1996,
unless received under a binding written
agreement, court decree, or mediation award
in effect on (or issued on or before)
September 13, 1995.
Although lawsuit
settlements of clearly designated punitive
damages received after August 20, 1996,
should be easily identified by the taxpayers
and the preparers as taxable proceeds, there
are still issues for examination. This guide
will provide information on how to identify
tax returns with lawsuit payment issues,
suggestions on conducting the examination;
detail of issues, explanations of applicable
terminology, synopses of several related
court cases, and exhibits of pertinent
forms.
Chapter 1, Issues
The following brief
synopsis reflects the similarities and
differences between the potential issues
which may arise in lawsuit verdicts and
settlements received prior to August 21,
1996, and those received on or subsequent to
that date.
Issues for Lawsuit Proceeds
Received Prior to August 21, 1996
-
Settlement proceeds are
unreported.
-
All punitive damages
are taxable whether received in relation
to a physical or non-physical injury
(caution: Alabama wrongful death cases).
-
Determine if any of the
settlement proceeds are designated as
interest, and if so, whether such
interest is reported as income.
-
For out of court
settlements, determine if the taxpayer
reported correct allocations between
taxable type awards, such as punitive,
back wages, etc., and non-taxable
amounts, such as emotional distress
damages (caution: back pay may be
excludable if received under
circumstances described in Rev. Rul.
93-88, 1993-2 C.B. 61, obsoleted by Rev.
Rul. 96-65, 1996-2 C.B. 6)
-
Verify that the
taxpayer reported taxable amounts at
gross rather than reporting them net of
legal fees.
-
Allowable legal fees
should be deducted on Schedule A as
miscellaneous itemized deductions,
unless the origin of the claim litigated
is related to a Schedule C (independent
contractor), or a capital transaction.
This guide does not address the proper
treatment of legal fees paid and
deducted in taxable years prior to the
year of recovery.
-
The legal fees deducted
on Schedule A are a tax preference item
for purposes of Alternative Minimum Tax
(AMT).
-
For purposes of the AMT
Credit, the legal fees which created
AMT, are not allowed to generate the
credit. They are "exclusion" items.
Issues for Lawsuit Proceeds
Received After August 20, 1996
-
Lawsuit proceeds are
unreported.
-
All punitive damages
are taxable whether received in relation
to a physical or non-physical injury
(caution: Alabama wrongful death cases).
-
Determine if any of the
settlement proceeds are designated as
interest, and if so, such interest is
reported as income.
-
Verify that amounts
excluded from income were received in a
case of physical injury. If it was not a
physical injury, the only amounts
excludable under IRC section 104(a)(2)
are out of pocket costs for medical
expenses incurred to treat emotional
distress.
-
For out of court
settlements for physical injury cases,
determine if proper amounts were
allocated between compensatory and
punitive damages.
-
Verify the amount of
out of pocket expense excluded for
emotional distress in a non-physical
injury case (that is, discrimination,
fraud, etc.).
-
Verify that the
taxpayer reported taxable amounts at
gross rather than reporting them net of
legal fees paid.
-
Allowable legal fees
should be deducted on Schedule A as
miscellaneous itemized deductions,
unless the origin of the claim litigated
is related to a Schedule C (independent
contractor), or a capital transaction.
This guide does not address the proper
treatment of legal fees paid and
deducted in taxable years prior to the
year of recovery.
-
The legal fees deducted
on Schedule A are a tax preference item
for purposes of AMT.
-
For purposes of the AMT
Credit, the legal fees which created
AMT, are not allowed to generate the
credit. They are "exclusion" items.
This comparison of issues
before and after the 1996 law changes
clearly reflects the fact that there is
still much potential for adjustments in the
area of lawsuit payments. By the time this
guide is available service wide, a large
portion of the examinations will probably be
relating to post- August 20, 1996, payments.
However, there may still be some pre-August
21, 1996, cases as well. For this reason,
this guide provides assistance in examining
the taxability of settlement payments
received both on or prior and subsequent to,
the amendment to IRC section 104 on August
20, 1996. (Note the exception to the
effective date of this amendment).
For taxable years beginning
after August 20, 1996, there will still be
issues relating to allocations in
out-of-court settlements. The allocation
issues will be particularly important in
out-of-court settlements for physical injury
cases. Because many cases are settled to
avoid the imposition of punitive damages, it
is anticipated that the some taxpayers may
erroneously allocate amounts between
excludable and punitive damages in these
cases. The allocation issue will not be as
important in the non-physical cases because
only out-of-pocket expenses for emotional
distress are excludable under IRC section
104(a)(2) after August 20, 1996.
Chapter 2, Taxability of
Lawsuit Payments
General rule relative to
taxability of amounts received from lawsuit
settlements:
IRC section 61
states that all income is taxable from
whatever source derived, unless exempted
by another section of the Code.
Terminology/Definitions
Types of Claims
Tort
-
May cause or
constitute, but is not necessarily, a
personal injury;
-
Any wrongful act, not
involving breach of contract, for which
a civil suit can be brought;
-
A wrongful act
committed by one person against another
person or his/her property;
-
The breach of a legal
duty imposed by law, other than by
contract.
Example 1:
X punches Y, thus committing the tort of
battery.
Example 2
X sets foot on Y's property, thus
committing the tort of trespass, but
causing no personal injury.
Contractual
-
Claims based on rights
given by contract.
Example 3
X forces Y to leave his employment
before the time specified in an
employment contract, thereby breaching
the contractual agreement.
Example 4
X refuses to pay Y the amount specified
in a homebuilding contract, thereby
breaching the contractual agreement.
Punitive
The tort offense was
committed:
-
Knowingly
-
Willingly
-
Deliberately
-
Negligently
-
Fraudulently.
Generally, punitive damages
are not awarded for simple breach of
contract, although lawsuits often combine
claims for breach of contract and related
tort claims in the same suit.
Types of Damages/Awards
Tort
-
May be received from
litigation or settlement of a claim for
physical injury or illness; mental pain
and suffering; interference with
economic relations and/or property
damage.
-
Usually non-taxable if
received in connection with a physical
injury or sickness. Property damages are
not excludable under IRC section
104(a)(2). Damages received for
invasions of economic interests are
generally taxable. See Gregg v.
Commissioner, T.C. Memo. 1999-10.
Exceptions:
-
Tax Benefit Rule -
If prior deductions under IRC
section 213 were taken (that is,
medical deductions; interest
expense, etc.) then amounts received
for reimbursement of these expenses
would be taxable to the extent
includable under IRC section 111.
-
Compensatory awards
from tort claims which represent
lost business receipts, or other
categories of taxable income may be
includable in income.
Contractual
-
A remedy provided
specifically by the contractual
agreement or as interpreted by a court.
-
Often paid for lost
wages and benefits, profits and other
forms of business receipts.
-
Usually taxable.
-
However, some amounts
may be non-taxable, for example, X
receives an insurance policy to replace
one previously purchased that had lapsed
due to an insurance agent's
misappropriation of premiums paid.
Compensatory
Generally speaking, most
people view the term "compensatory" to mean
"nontaxable." However, as the above examples
reflect, determinations of the taxability of
lawsuit awards cannot always be made simply
by referring to the terminology used, that
is, compensatory or contractual.
The term "compensatory"
merely means that the payment compensated
the taxpayer for a loss. This loss may be
purely economic, for example, arising out of
a contract, or personal, for example,
sustained by virtue of a physical injury.
Furthermore, not all torts constitute
personal injuries. Some torts may involve
invasion of property rights, for example,
conversion, or interference with economic
interests, for example, tortious
interference with contractual relations, or
purely personal interests, for example,
defamation. Further, even in tort cases,
where the damages compensate for the
aggravated manner in which the defendant
committed the tortious act, such damages are
not received on account of any personal
injury.
The facts and circumstances
of each lawsuit settlement must be
considered to determine the purpose for
which the money was received. Then, it can
be determined whether these amounts are
excludable.
Punitive
-
To Punish
-
Taxable. (Caution:
Alabama wrongful death proceeds)
Types of Settlements
Determining the correct
allocations among taxable payments and
non-taxable payments is usually the most
difficult part of these examinations. There
are two ways in which settlement proceeds
are originally categorized:
Jury/Court Verdicts
If damages have been
clearly allocated to an identifiable claim
in an adversarial proceeding by judge or
jury, the Service will usually not challenge
their character because of the impartial and
objective nature of the determinations. But
see Robinson v. Commissioner, 102 T.C. 116,
122 (1994) and Kightlinger v. Commissioner,
T.C. Memo. 1998-357.
Settlements Out of
Court
Many lawsuits are settled
prior to a jury verdict. These settlements
should be closely reviewed, and facts and
circumstances should be carefully
determined. The allocation among the various
claims of the settlement can be challenged
where the facts and circumstances indicate
that the allocation does not reflect the
economic substance of the settlement. See
Phoenix Coal
Company, Inc. v.
Commissioner (CA-2) 56-1 U.S.T.C. 9366,
231 F.2d 420 (2d Cir. 1956); Robinson v.
Commissioner, 102 T.C 116, 122 (1994);
Bagley v. Commissioner, 105 T.C. 396 (1995),
aff'd, 121 F.3d 393 (8th Cir. 1997).
LeFleur v. Commissioner,
T.C. Memo. 1997-312 addresses the
reallocation issue in a case involving
claims for breach of contract, emotional
distress, and punitive damages. In an
out-of-court written settlement, the payment
was allocated as $200,000 to contract,
$800,000 to emotional distress, and $0 to
punitive damages. The taxpayer excluded the
$800,000 from income under IRC section
104(a)(2).
The Service disregarded the
terms of the written settlement agreement
and reallocated the $800,000 to
contract/punitive damages. The Tax Court
upheld the IRS reallocation. Referring to
the settlement, the court stated that "the
allocation did not accurately reflect the
realities of the petitioner's underlying
claims." In determining that the $800,000
was not excludable under IRC section
104(a)(2), the court stated:
"In light of the facts
and circumstances, we conclude that
petitioner suffered no injury to his
health that could be attributed to the
actions of the defendants, and we are
not persuaded that such injury was the
basis of any payment to him by Blount."
For additional information
on issues dealing with allocation or
reallocation, see the following sections on
"Physical Personal Injury or Sickness" and
"Non-Physical Personal Injury or Sickness."
Tax Treatment of Awards and
Settlements
Awards and settlements can
basically be divided into two distinct
groups. One group includes claims arising
from a physical injury and the other group
includes those arising from a non-physical
injury. The claims from each of the two
major groups will usually fall into three
categories:
-
Actual damages
resulting from the physical or
non-physical injury;
-
Emotional distress
damages arising from the actual physical
or non-physical injury; and
-
Punitive damages.
Physical Personal
Injury or Sickness
Physical
IRC section 104(a)(2)
provides for an exclusion from gross income
for damages received (whether by suit or
agreement and whether as lump sums or as
periodic payments) on account of personal
injury or sickness.
Section 7641 of the Omnibus
Budget Reconciliation Act of 1989 amended
IRC section 104(a)(2) by adding flush
language: "Paragraph (2) shall not apply to
any punitive damages in connection with a
case not involving physical injury or
physical sickness." This amendment applies
to punitive damages received after July 10,
1989, in tax years ending after that date.
Nevertheless, some
taxpayers have erroneously failed to report
as income almost all types of
awards/settlements under IRC section
104(a)(2) due to personal injury. The
Service has consistently held that
compensatory damages, including lost wages,
received on account of a physical injury are
excludable from gross income. Rev. Rul.
85-97, 1985-2 C.B. 50, amplifying Rev. Rul.
61-1, 1961-1 C.B. 14. See also Commissioner
v. Schleier, 515 U.S. 323, 329-330 (1995),
in which the Supreme Court, employing a
similar set of facts as the ruling, held
that medical expenses not previously
deducted, pain and suffering damages, and
lost wages received by accident victim are
excludable from income.
IRC section 104(a)(2) was
amended in 1996. The amended section
104(a)(2) excludes from gross income damages
received on account of personal physical
injury or physical sickness only. However,
the limitation to personal physical injuries
or physical sickness contained in the 1996
amendment does not apply to any amount
received under a written binding agree-ment,
court decree, or mediation award in effect
on (or issued on or before) September 13,
1995.
The House Committee Report
for the 1996 changes (excerpts attached as
Appendix D) states:
If an action has its origin
in a physical injury or physical sickness,
then all damages (other than punitive) that
flow therefrom are treated as payments
received on account of physical injury or
physical sickness whether or not the
recipient of the damages is the injured
party. For example, damages (other than
punitive) received by an individual on
account of a claim for loss of consortium
due to the physical injury or physical
sickness of such individual's spouse are
excludable from gross income.
Emotional
The exclusion from gross
income under IRC section 104(a)(2) also
applies to any compensatory damages received
based on a claim of emotional distress or
mental/emotional injury that is attributable
to a physical injury or physical sickness.
For more information on damages paid for
emotional injuries stemming from physical
injury/sickness, see discussion under
"Physical" above. Emotional claims
pertaining to non-physical personal
injury/sickness" is covered later on in this
guide.
Determining the amounts
allocable to mental/emotional injuries may
not always be easy. The facts and
circumstances of each award/settlement must
be examined, and amounts which can be
reasonably allocated to genuine mental
injury should be allowed. The allocation is
necessary when economic damages, for
example, back pay, or punitive damages is
requested as relief in a case involving a
physical or non-physical personal injury.
-
Points to consider:
-
Did payor intend to
compensate the recipient for his or
her claim of mental distress? If so,
how much? But see Hemelt v. United
States, 122 F.3d at 208 ("the
characterization of a settlement
cannot depend entirely on the intent
of the parties") citing Dotson v.
United States, 87 F.3d at 687, and
Mayberry v. United States, 151 F.3d
at 859.
-
What did the payor
think? That is, whether he/she/it
could win or lose (elements of the
claim).
-
Were there medical
bills for mental disturbances?
-
Was there
psychological treatment or
counseling?
-
Were there lost
workdays?
-
Is there
documentation for medications,
antidepressants, etc?
-
Did this situation
cause taxpayer to be absent from
work?
-
Was there sick
leave used?
-
Did taxpayer
continue to care for his/her family?
-
Did taxpayer
continue with daily affairs?
For the allocation,
start with the total payment less the
actual, obvious losses, then allocate
between compensatory and punitive.
Punitive Damages
-
Punitive damages
are not excludable from gross income
under IRC section 104(a)(2).
The position of the IRS
on the taxation of punitive damages has
not been constant. In Rev. Rul. 58-418,
1958-2 C.B. 18, the Service published
its position that punitive damages do
not qualify for exclusion under IRC
section 104(a)(2). See Thomson v.
Commissioner, 406 F.2d 1006, 69-1
U.S.T.C. 9199 (9th Cir. 1969). In Rev.
Rul. 75-45, 1975-1 C.B. 47, the Service
changed its position and concluded that
punitive damages were excludable. See
Roemer v. Commissioner, 716 F.2d 693,
83-2 U.S.T.C. 9600 (9th Cir. 1983),
following the Service reluctantly on
this issue. Addressing the Alabama
wrongful death statute, the Service
ruled that punitive damages were again
taxable. Rev. Rul. 84-108, 1984-2 C.B.
32. Accordingly, Rev. Rul. 75-45 was
revoked. See Burford v. United States,
642 F. Supp. 635 (N.D. Ala. 1986),
disagreeing with Rev. Rul. 84-108. Prior
to 1989, the courts, however, often did
not agree. After 1989, some commentators
believed that the courts would interpret
the additional verbiage to IRC section
104(a)(2) to exclude punitive damages
paid relative to a physical injury or
physical sickness.
However, in the Tenth
Circuit's decision in O'Gilvie v. United
States, 95-2 U.S.T.C., 50,508, 66 F.3d
1550, the court ruled that
"non-compensatory punitive damages are
not received on account of personal
injuries, and thus are not excludable
from gross income under IRC section
104(a)(2)."
In O'Gilvie, the Tenth
Circuit applied the Supreme Court's
ruling in the case of Commissioner v.
Schleier, (1995 S.Ct.), 75 AFTR 2d
95-2675; 115 S.Ct. 2159, 515 U.S. 323,
involving employment discrimination, to
a case involving wrongful death.
Schleier held that there are two
independent tests which must be met for
the IRC section 104(a)(2) exclusion to
apply: (1) The underlying cause of
action giving rise to the recovery must
be based on tort or tort-type rights;
and (2) the damages must "have been
received on account of personal injuries
or sickness."
Prior to this time,
some of the courts had relied on only
the first requirement of a tort-type
underlying claim in holding that the
damages were excludable. See, for
example, Hill v. United States, 733 F.
Supp. 88, 1990-1 U.S.T.C. 50,170 (D.
Kan. 1990) (damages for tort of
misrepresentation excludable from gross
income).
The Supreme Court
upheld the Tenth Circuit's decision.
O'Gilvie 519 U.S. 79, 117 S. Ct. 452;
96-2 U.S.T.C. 50,664; 78 AFTR 2d 7454
(1996). With this decision, the courts
finally have clear guidance, which
coincides with the Service's position on
the taxation of punitive damages prior
to the 1989 amendment to IRC section
104(a)(2).
With the enactment of
Public Law 104-188, Section 1605(d),
Congress made it clear in IRC section
104(a)(2) that punitive damages are
taxable, regardless of the nature of the
underlying claim.
However, the courts
have not decided a case involving
punitive damages subject to the 1989
amendment to IRC section 104(a)(2). In
dictum, the Supreme Court indicated that
Congress amended IRC section 104(a)(2)
in 1989 to allow the exclusion of
punitive damages only in cases involving
physical injury or physical sickness.
United States v. Burke, 504 U.S. at 236,
n.6. Faced with the taxation of punitive
damages prior to the 1989 amendment and
the specter of addressing the 1989
amendment in a subsequent case, the
Supreme Court, retreating from the
statement in Burke, rejected the
taxpayer's argument that was based on
this dictum. O'Gilvie, 519 U.S. at
89-90. The Court indicated that
Congress' focus in 1989 was on what to
do about non-physical personal injuries
rather than on punitive damages under
prior law. The Court's statement lays to
rest the negative inference and provides
support for the conclusion that, in
enacting the 1989 amendment, Congress
did not intend to create an exclusion
for punitive damages received in
connection with a physical injury or
physical sickness. See, also, Miller v.
Commissioner, 914 F.2d 586, 588, n. 4
(4th Cir. 1990) (Congress has amended
IRC section 104(a)(2) so that it now
explicitly does not exclude from gross
income "punitive damages received in
connection with a case not involving
physical injury or physical sickness.")
Wrongful Death
Claims for wrongful death
usually encompass compensatory damages for
physical and mental injury, as well as
punitive damages for reckless, malicious, or
reprehensible conduct. As a result, both
claims may generate settlement amounts. Any
amounts determined to be compensatory for
the personal injuries are excludable from
gross income under IRC section 104(a)(2).
The amounts determined to be
non-compensatory, that is, punitive
payments, are not excludable under IRC
section 104(a)(2). This is true regardless
of whether the punitive amounts are received
prior or subsequent to the August 20, 1996,
amendment. (See O'Gilvie, 519 U.S. 79, 117
S. Ct. 452; 96-2 U.S.T.C. 50,664; 78 AFTR 2d
7454.)
The exclusion available for
personal injuries under IRC section
104(a)(2), as of August 20, 1996, reads as
follows:
"* * * the amount of
any damages (other than punitive
damages) received (whether by suit or
agreement and whether as lump sums or as
periodic payments) on account of
personal physical injuries or physical
sickness."
As mentioned previously,
caution should be used in applying this
general rule that punitive damages received
in wrongful death cases are taxable. The
courts have generally looked to the state
statute under which the wrongful death claim
was litigated to determine whether there
could be compensatory and/or punitive
damages awarded. This search, at times, has
revealed a state statute, which provides
only for punitive damages in wrongful death
claims. One court has ruled, that such
damages received in wrongful death cases in
that state are excludable from income.
Burford v. United States, 642 F. Supp. 635
(N.D. Ala. 1986). The court's reasoning was
that because the taxpayer is precluded from
receiving any compensatory amounts, it is
unfair to tax the amounts although they were
classified as punitive.
Questions have arisen as to
whether the 1996 amendment codified this
judicial treatment of punitive damages in
Burford. A new provision, IRC section
104(c), provides as follows:
(c) Application of
prior law in certain cases.
The phrase "other than punitive damages"
shall not apply to punitive damages
awarded in a civil action -
(1) which is a wrongful death action,
and
(2) with respect to which applicable
State law (as in effect on September 13,
1995, and without regard to any
modification after such date) provides,
or has been construed to provide by a
court of competent jurisdiction pursuant
to a decision issued on or before
September 13, 1995, that only punitive
damages may be awarded in such an
action.
Due to the inference raised
by this language in the wrongful death
claims area, it may become necessary to
determine if your state is one having a
statute precluding the awarding of
compensatory damages in wrongful death
cases. If that is the case, then contact the
Office of Chief Counsel for guidance on
Service position.
Product Liability
Product liability cases
often include claims for personal physical
and mental injury. For example, X brings a
claim for personal injury against an auto
manufacturer claiming a wreck was caused by
a faulty steering column on his car, or Y
brings suit against the manufacturer of a
contaminated pesticide claiming damage to
ornamental plants and the nursery, and
injury to business reputation.
These type cases will
usually involve the various elements
discussed above, relative to compensatory
damages for physical and mental injury, as
well as punitive damages. Proper allocations
among the taxable and nontaxable portions
received must be determined.
Non-Physical Personal
Injury or Sickness
Prior to the amendment of
August 20, 1996, the Service and the courts
consistently interpreted IRC section
104(a)(2) as providing an exclusion for
damages received in connection with claims
of mental and emotional distress which arose
from non-physical injuries. Examples of
these type cases are employment wrongful
discharge; discrimination; libel; etc.
Exclusions from gross income have been
widely debated in prior years. Generally,
the Service has challenged taxpayers'
allocation of settlement proceeds to
compensatory damages for mental/emotional
distress when those allocations do not
reasonably reflect the economics of the
underlying claim. Thus, whether the Service
must respect the specific allocations
contained in a settlement agreement has
arisen in several cases. The same
considerations to proper allocations for
emotional claims that were discussed earlier
under "physical injuries" are applicable to
the non-physical cases as well. (Refer to
comments under "Emotional".)
The August 20, 1996,
amendment has plainly resolved this issue on
the side of the Government. With the
exception of amounts paid to treat emotional
distress, damages received after August 20,
1996, are excludable under IRC section
104(a)(2) only if received on account of
physical injury or physical sickness.
The 1996 amendment changed
the last sentence in paragraph (a) of IRC
section 104 to include the following:
For purposes of paragraph
(2), emotional distress shall not be treated
as a physical injury or physical sickness.
The preceding sentence shall not apply to an
amount of damages not in excess of the
amount paid for medical care (described in
subparagraph (A) or (B) of section
213(d)(1)) attributable to emotional
distress.
The House Committee Report
on the 1996 amendment to IRC section
104(a)(2) states:
* * * the exclusion
from gross income does not apply to any
damages received (other than for medical
expenses as discussed below) based on a
claim of employment discrimination or
injury to reputation accompanied by a
claim of emotional distress * * * In
addition, the exclusion from gross
income specifically applies to the
amount of damages received that is not
in excess of the amount paid for medical
care attributable to emotional distress.
As a result of the above
1996 changes to IRC section 104(a)(2), a
taxpayer receiving lawsuit proceeds from a
non-physical injury claim cannot exclude any
amount for payment to compensate for an
intangible emotional distress value. The
taxpayer can only exclude an amount for
actual out of pocket medical costs. This
exclusion would further depend upon whether
the taxpayer had previously deducted those
medical expenses on his or her tax return.
See IRC sections 111 and 213.
Employment-Related
Employment-related lawsuits
may arise from wrongful discharge or failure
to honor contract obligations. Whether a
wrongful termination constitutes a tort
under applicable state law is not
controlling for IRC section 104(a)(2)
purposes. As indicated earlier, the victim
of a tort may suffer both personal injury
and economic loss. Damages received to
compensate for economic loss, for example,
lost wages, business income, benefits, are
not excludable from gross income unless a
personal injury caused such loss.
If the payments in question
are received prior to the 1996 amendment,
there may be issues concerning the proper
allocation between taxable and nontaxable
proceeds. The taxpayer may be seeking to
exclude substantial amounts for
emotional/mental distress. After the 1996
changes, the taxpayer can exclude under IRC
section 104(a)(2) only an amount of damages
received not exceeding medical costs paid to
treat any emotional distress.
Discrimination Suits
(Employment-Related)
Discrimination suits
usually are brought alleging infringements
in the areas of age, race, gender, religion
or disability. These types of cases can
generate compensatory, contractual and
punitive awards. Historically, the courts
have usually looked to the
underlying-cause-of-action statute to
determine the nature of remedies allowed for
the various types of discrimination.
Some courts, and, for a
short time, the Service, permitted taxpayers
to exclude amounts awarded which actually
represented back pay. Rev. Rul. 93-88 was
based on the interpretation of the Supreme
Court's ruling in Burke, 504 U.S. 229 (69
AFTR 2d 92-1293). Rev. Rul. 93-88 held that
amounts received under the following
provisions, including, not only amounts for
non-pecuniary losses, but back pay as well,
were excludable under IRC section 104(a)(2):
-
Gender discrimination
claims under the disparate treatment
provisions of Title VII of the Civil
Rights Act of 1964, 42 U.S.C. section
2000e et seq., as amended by the Civil
Rights Act of 1991, 42 U.S.C. section
1981a;
-
Racial discrimination
claims under, 42 U.S.C., section 1981,
and Title VII of the Civil Rights Act of
1964; and
-
Discrimination claims
under the Americans with Disabilities
Act, 42 U.S.C. sections 12101-12213.
The decision of the Supreme
Court in the Schleier case, (1995, S. Ct.)
515 U.S. 323, 115 S. Ct. 2159, caused the
Service to suspend Rev. Rul. 93-88 with the
issuance of Notice 95-45, 1995-2 C.B. 330,
on August 3, 1995. Notice 95-45 stated the
following:
In Schleier, the Supreme
Court held that back pay and liquidated
damages received in settlement of a claim
under the Age Discrimination in Employment
Act of 1967, 29 U.S.C sections 621-634
(ADEA), are not excludable from gross income
under section 104(a)(2). The Court concluded
that section 104(a)(2) and its regulations
set forth two requirements for a recovery to
be excludable from income: (1) it must be
based on tort or tort-type rights, and (2)
it must be received "on account of personal
injuries or sickness." The Court held that
back pay and liquidated damages received
under the ADEA meet neither requirement
because (1) the ADEA provides no
compensation for any of the other
traditional harms associated with personal
injury, (2) the back pay is completely
independent of the existence or extent of
any personal injury, and (3) the ADEA
liquidated damages are punitive in nature.
In Notice 95-45, the
Service requested public comments concerning
the impact of Schleier on the above listed
statutes; allocation of the excludable and
nonexcludable portions of lump-sum awards
and settlements; and the extent to which IRC
section 7805(b) relief should be granted in
the event that guidance previously issued by
the Service is modified. Notice 95-45 was
superseded when the Service published Rev.
Rul. 96-65, 1996-2 C.B. 6, in December of
1996.
After providing a brief
history of the law and rulings relating to
the discrimination cases, Rev. Rul. 96-65
holds:
-
Current section
104(a)(2) - (after August 20, 1996) Back
pay received in satisfaction of a claim
for denial of a promotion due to
disparate treatment employment
discrimination under Title VII is not
excludable from gross income under
section 104(a)(2) because it is
completely independent of, and thus is
not damages received on account of,
personal physical injuries or physical
sickness under that section. Similarly,
amounts received for emotional distress
in satisfaction of such a claim are not
excludable from gross income under
section 104(a)(2), except to the extent
they are damages paid for medical care
(as described in section 213(d)(1)(A) or
(B)) attributable to emotional distress.
-
Former section
104(a)(2). Back pay received in
satisfaction of a claim for denial of a
promotion due to disparate treatment
employment discrimination under Title
VII is not excludable from gross income
under former section 104(a)(2) because
it is completely independent of, and
thus is not damages received on account
of, personal injuries or sickness under
that section. However, damages received
for emotional distress in satisfaction
of such a claim are excludable from
gross income under former section
104(a)(2) because they are received "on
account of personal injuries of
sickness."
Pursuant to the authority
contained in IRC section 7805(b), Rev. Rul.
96-65 will not apply adversely to damages
received under any provision of law
providing tort or tort-type remedies for
employment discrimination for race, color,
religion, gender, national origin, or other
similar classifications, if the damages are
received (1) on or before June 14, 1995, the
date that Schleier was decided by the
Supreme Court, or (2) pursuant to a written
binding agreement, court decree, or
mediation award in effect on (or issued on
or before) June 14, 1995.
Rev. Rul. 96-65 also
contains information concerning its effect
on other rulings and references to treatment
of amounts as wages and compensation. Rev.
Rul. 96-65 should be consulted for guidance
in certain employment discrimination cases.
The provisions of Rev. Rul. 96-65 apply to
proceeds received for employment
discrimination that is also prohibited by
certain state and local laws. Rev. Rul.
93-88, although made obsolete by Rev. Rul.
96-65, contains a good explanation of
various discrimination statutes.
Libel (Defamation of
Character)
Prior to the 1996 amendment
to IRC section 104, the government and the
courts were at odds on the proper tax
treatment of awards due to damage of
business reputation. The government took the
position that these damages could not be
excluded from income. See Rev. Rul. 58-418,
1958-2 C.B. 18.
Although the Tax Court
initially agreed with the government, Roemer
v. Commissioner, 79 T.C. 398 (1982), rev'd,
716 F.2d 693 (9th Cir. 1983), it adopted the
circuit court's rationale in Threlkeld v.
Commissioner, 87 T.C. 1294 (1986), aff'd,
848 F.2d 81 (6th Cir. 1988). As a result,
the courts allowed taxpayers to exclude from
gross income compensatory amounts received
for injury to business reputation and
malicious prosecution. See also Srivastava
v. Commissioner, T.C. Memo. 1998-362
(defamation of a person is a personal injury
under state law).
Recently, however, the Tax
Court revisited this issue and concluded
that damages received for injury to the
taxpayer's business or professional
reputation failed to qualify for the IRC
section 104(a)(2) exclusion. Fabry v.
Commissioner, 111 T.C. 305 (1998). The court
held that whether damage to an individual's
business or professional reputation
constitutes a personal injury for IRC
section 104(a)(2) purposes is an issue of
fact, rather than a question of law. Because
the taxpayer failed to allege any personal
injury in the underlying product liability
action, the court concluded that the portion
of the proceeds allocable to injury to
taxpayer's business reputation was not
excludable under IRC section 104(a)(2).
Fabry was decided under IRC section
104(a)(2) as it existed prior to the 1996
amendment.
However, the 1996 changes
to IRC section 104(a)(2) should resolve this
issue on the side of the government as well.
Because damage to reputation, be it personal
or business, is a non-physical injury, only
out of pocket costs to treat emotional
distress can be excluded. Any other
compensatory and punitive damages arising
from these cases are taxable.
Other Non-Physical
Personal Injury
Lawsuits against insurance
companies, finance companies, etc., for
negligence, fraud, breach of contract, etc.,
can include a variety of claims, and
therefore can produce a variety of types of
awards/settlements.
For amounts received prior
to August 21, 1996, the facts and
circumstances of each case must be analyzed
to determine the reasonable allocations
between taxable and nontaxable amounts. Some
taxpayers may erroneously categorize
punitive damages and other non-compensatory
amounts received in these cases as amounts
received for personal injuries related to
emotional distress.
Subsequent to August 1996,
the taxable amounts in these cases are more
easily determined. Because these are
nonphysical injuries, under the current
version of IRC section 104(a)(2), only
out-of-pocket amounts for medical costs
incurred to treat any emotional distress
claims would be excludable from income. All
amounts determined to represent punitive
damages are taxable.
Chapter 3,
Other Related Topics
Payroll and
Self-Employment Tax
Considerations
Questions may
arise concerning pursuit of
employment taxes on cases
involving employment- related
issues, and self-employment
taxes on cases involving
payments to self-employed
persons related to their trade
or business.
The employment
taxes that may apply include the
taxes imposed under the Federal
Insurance Contributions Act
(FICA), the Federal Unemployment
Tax Act (FUTA), and the
Collection of Income Tax at
Source on Wages (income tax
withholding). If the taxpayer is
a railroad employer, the
Railroad Retirement Tax Act
(RRTA) may apply. FICA taxes,
FUTA taxes, and income tax
withholding are imposed on
"wages" as defined in the
Internal Revenue Code. "Wages"
is broadly defined as "all
remuneration for employment,"
with certain specific
exceptions, for FICA and FUTA
purposes (IRC sections 3121(a)
and 3306(b), respectively) and
"all remuneration for services
performed by an employee for his
employer," again with specific
exceptions, for income tax
withholding purposes (IRC
section 3401(a)).
In determining
the status of settlement
payments, keep in mind the broad
definitions of "wages." See
Social Security Board v.
Nierotko, 327 U.S. 358 (1946),
and Hemelt v. United States, 122
F.3d 204, 209-211 (4th Cir.
1997).
Be aware that
the label placed on settlement
payments by the plaintiff and
the defendant does not
necessarily control the
employment tax treatment of such
payments. Because both parties
generally benefit by classifying
payments as non-wage payments,
the specific portion of a
settlement agreement allocating
payments to non-wage payments is
generally not based on an arm's
length negotiation between
adverse parties.
An allocation
of the settlement that is
reasonable and based on the
facts and circumstances of the
case should generally be
accepted by the Service. A
statement by the employer that
the settlement payment was made
merely to settle the case is of
little value in determining
whether the payment is wages for
employment tax purposes.
Generally, if no specific
allocation of the settlement is
made, the status of the payments
would be determined by looking
at the claims asserted by the
plaintiff and the surrounding
facts and circumstances,
including the basis upon which
the settlement proceeds were
distributed. There has been a
considerable amount of
litigation in connection with
the employment taxation of
settlement payments, therefore,
before relying on any particular
case, care should be taken to
verify that the case accurately
reflects Service position.
There is
general agreement that to the
extent damages are excludable
from gross income, they are not
subject to employment taxes.
Also, there is general agreement
among courts that to the extent
a settlement payment made by an
employer or former employer
represents back pay for services
by an employee for the employer,
such payments are wages for
employment tax purposes. Rev.
Rul. 96-65, 1996-2 C.B. 6.
Back pay paid
to an employee or former
employee by an employer in a
settlement related to a claim
under a workers' right statute
or civil rights statute for a
period during which no services
were performed by the employee
is also wages for federal
employment tax purposes.
Typically, back pay is awarded
if an employee is illegally
terminated by an employer, and,
under those circumstances, the
back pay relates to a period
when no services for the
employer were performed by the
employee because of the illegal
termination. The position that
back pay is wages even though it
is attributable to a period
during which actual services
were not performed is based on
the Supreme Court's holding in
Social Security Board v.
Nierotko, 327 U.S. 358 (1946),
in which back pay awarded to an
illegally terminated employee
under the Fair Labor Standards
Act (FLSA) was held to be wages
for social security benefit
purposes.
Nierotko has
been applied in determining that
wages for federal employment tax
purposes includes back pay paid
under a number of different
workers' rights and civil rights
statutes (for example, the Back
Pay Act, the Age Discrimination
in Employment Act (ADEA), and
Title VII of the Civil Rights
Act of 1964, and state and local
discrimination statutes). See
Tanaka v. Department of Navy,
788 F.2d 1552, 1553 (Fed. Cir.
1986), and Blim v. Western
Electric Co., 731 F.2d 1473,
1480 n.2 (10th Cir. 1980). But
see Churchill v. Star
Enterprises, 3 F. Supp. 2d 622,
624-25 (E.D. Pa. 1998) holding
that an employer could not
withhold FICA or income taxes
from damages awarded for a
violation of the Family and
Medical Leave Act, 29 U.S.C.
section 2601 et seq, because the
employee was not performing
services for the employer during
the period for which the damages
were awarded.
Service
position is that "front pay",
which is pay awarded to the
employee for future services
(that is, generally service from
the date of the settlement going
forward) the employee would have
performed but for the illegal
actions of the employer, is also
wages for federal employment tax
purposes. Some courts have
disagreed with this position.
See Dotson v. United States, 87
F.3d 682, 690 (5th Cir. 1996),
holding that payments are not
wages if not for services
already performed. However,
Nierotko supports the Service
position. In addition, Service
position is that settlements
including cash payments made to
employees by employers in lieu
of providing benefits under
employer plans (for example,
paid in lieu of health insurance
or qualified pension plan
benefits) are also wages for
federal employment tax purposes,
because no exception from wages
applies.
Back pay and
front pay are wages subject to
employment taxes in the year
paid, and are subject to the tax
rates and FICA and FUTA wage
bases in effect in the year
paid. See Rev. Rul. 89-35,
1989-1 C.B. 280; Hemelt v.
United States, 122 F.3d 204, 210
(4th Cir. 1997); and Mazur v.
Commissioner, 386 F. Supp. 752
(W.D. N.Y. 1997). The Service
does not follow Bowman v. United
States, 824 F.2d 528 (6th Cir.
1987), on the timing of FICA
taxation of back pay issue.
There has been
much litigation in the area of
the employment tax status of
settlement agreements, and the
Service position has not been
followed in many cases. For
example, the issue of whether
certain payments in settlement
of a suit for violation of
Employee Retirement Income
Security Act (ERISA) are subject
to income and FICA taxes has
been litigated in four circuits.
These cases related to a class
action brought by former
employees of an employer who
engaged in a scheme of
terminating employees before
they qualified for certain
pension benefits. Two circuits
agreed with the Government's
position that the full amount of
the settlements were includable
in income and
subject to FICA
taxes. See Hemelt v. United
States, 122 F.3d 204 (4th Cir.
1997), and Mayberry v. United
States, 151 F.3d 855 (8th Cir.
1998). However, in Dotson v.
United States, 87 F.3d 682 (5th
Cir. 1996), the Fifth Circuit
Court of Appeals held that only
the back pay portion of the
settlement was wages for FICA
tax purposes. In Gerbec v.
United States, 164 F.3d 1015
(6th Cir. 1999), the Court of
Appeals for the Sixth Circuit
held that only the portions of
the settlement representing back
pay and the front pay not
attributable to personal injury
were subject to FICA taxes. In
looking at these four cases,
please be aware that the income
tax result does not reflect the
recent amendment to IRC section
104(a)(2) and that the income
and FICA tax results in the
cases the Government lost do not
reflect Mertens v. Hewitt
Associates, 508 U.S. 248 (1993),
a Supreme Court case which
provides that tort damages are
not available for ERISA
violations.
In addition,
the Service's position is that
back wages and front pay paid to
individuals who are not hired as
employees because of violation
of workers' rights or civil
rights statutes are wages for
federal employment tax purposes.
See Rev. Rul. 78-176, 1978-1
C.B. 303, which bases its
holding on Nierotko. However,
the position of this revenue
ruling was rejected in Newhouse
v. McCormick & Co., 157 F.3d 582
(8th Cir. 1998).
As a general
rule, dismissal pay, severance
pay, or other payments for
involuntary termination of
employment are wages for federal
employment tax purposes. See
Rev. Rul. 90-72, 1990-2 C.B.
211, and Rev. Rul. 73-166,
1973-1 C.B. 411. See also
Abrahamsen v. United States, 44
Fed. Cl. 260 (1999), on
downsizing payments. In that
consolidated case, approximately
2,600 former employees of IBM
sought refunds of income and
FICA taxes on the basis that
payments received under certain
resource reduction programs were
excludable from gross income as
personal injury damages and
consequently were not wages.
Noting that none of the
plaintiffs instituted a claim
against IBM before executing
releases and receiving the
payments, the court doubted that
they satisfied the first test
for exclusion. Even if they did
satisfy that test, the court
concluded that the plaintiffs
failed to satisfy the second
test that the payments were
received "on account of personal
injuries." On the FICA issue,
the court reasoned that because
the payments were linked to
salary and length of tenure, the
payments were consistent with
the notion of wages.
There are a
number of exceptions to wages
that may apply in settlement
cases. For example, legally
designated interest and attorney
fees may be excepted from wages.
Rev. Rul. 80-364, 1980-2 C.B.
294. Also, a limited exception
exists for certain settlement
payments made to settle claims
for the cancellation of the
remaining period of a contract
for a term of years that is
terminated prior to the
completion of the contract. See
Rev. Rul. 55-520, 1955-2 C.B.
393, and Rev. Rul. 58-301,
1958-1 C.B. 23. These two
rulings should be applied only
when the facts of the case are
identical to the rulings, and
comparison should be made with
Rev. Rul. 74-252, 1974-1 C.B.
287, and Rev. Rul. 75-44, 1975-1
C.B.15, before applying Rev.
Rul. 55-520 or Rev. Rul. 58-301
in any particular case.
"Liquidated
damages" awarded under a FLSA
settlement are not wages for
federal employment tax purposes.
Rev. Rul. 72-268, 1972-1 C.B.
313. Under the FLSA such
liquidated damages cannot exceed
the amount of back pay and must
be based on a showing of willful
intent of the employer. Similar
rules apply to "liquidated
damages" under the ADEA.
Generally, bona fide damages in
settlement of tort claims for
personal injury that were
excludable from gross income
under IRC section 104(a)(2) do
not constitute wages for federal
employment tax purposes. See
Hemelt, 122 F.3d at 210.
In the case of
a lawsuit settlement paid by an
employer to an employee or
former employee, caution should
be exercised in determining the
existence of any employment tax
issues.
In contrast to
the broad definition of wages
for federal employment tax
purposes set forth in Nierotko
and other cases, many recent
cases have adopted narrow
interpretations of what
constitutes "self-employment
income" for self-employment tax
purposes. See IRC section
1402(a) and (b). Under the test
adopted by many courts, to be
included in self-employment
income for self-employment tax
purposes, "any income must arise
from some actual (whether
present, past, or future)
income-producing activity of the
taxpayer." See Newberry v.
Commissioner, 76 T.C. 441
(1981), in which business
interruption insurance payments
paid to a self-employed
individual during the period his
store was shut down because of a
fire were held not to be
self-employment income, and
Jackson v. Commissioner, 108
T.C. 130, in which certain
termination payments made to a
retiring insurance agent were
held not to be includable in
self-employment income. See,
however, Rev. Rul. 91-19, 1991-1
C.B. 186, in which the Service
sets forth a slightly different
test for inclusion in
self-employment income.
Thus, before
classifying settlement payments
as subject to self-employment
tax, care should be taken in
determining that the payments
can be attributed to the
carrying on of a trade or
business by the self-employed
person.
Amount to be
Included in Income
In cases
involving contingent fee
arrangements, the gross
award/settlement, without
diminution for attorneys' fees
or costs, should be included in
the taxpayer's income. This
treatment is in accord with IRC
section 61 and the long
established principle, "the
fruit of the tree" theory, that
income is taxable to the person
who earns it and it cannot be
assigned to someone else.
Taxing the
gross amount from lawsuit
proceeds has been upheld in Tax
Court, as well as various
circuit jurisdictions. See
Gadlow, 50 T.C. 975,
(1968)(Pennsylvania); Baylin, 43
F.3d 1451, 94-1 U.S.T.C. 50,029
(Fed. Cir. 1993)(Maryland);
Alexander, 72 F.3d 938, 96-1
U.S.T.C. 50,011 (1st Cir. 1995),
aff'g T.C. Memo.
1995-51(Massachusetts); Coady,
T.C. Memo. 1998-291 aff'd, 231
F3d 1187 (9th Cir.
2000)(Alaska); Srivastava, T.C.
Memo. 1998-362, rev'd, 86 AFTR2d
2000-5104 (Texas); Sinyard, T.C.
Memo. 1998-364(Arizona); and
Benci-Woodward, T.C. Memo.
1998-395, aff'd, 86 AFTR2d
2000-5102 (9th Cir. 2000)
(California); Kenseth, 114 T.C.
No. 26 (May 24, 2000). In
Kenseth, the Tax Court held that
the anticipatory assignment
principles require a taxpayer to
include in gross income the
entire amount of
judgment/settlement proceeds,
undiminished by any contingent
fee and regardless of the state
where a fee agreement is signed.
The Tax Court expressly rejected
the principles enunciated in
cases holding to the contrary.
Examiners
handling cases involving
payments of attorneys' fees in
lawsuits in Alabama, Michigan,
and Texas, however, should be
aware that there is contrary
authority based on an
interpretation of applicable
state law.
In Cotnam v.
Commissioner, 1959, 263 F.2d
119, 59-1 U.S.T.C. 9200, rev'g
on this issue, 28 T.C. 947
(1957), the Fifth Circuit, one
judge dissenting, determined
that attorneys' fees paid
directly to the attorney from
the judgment under a contingency
fee arrangement were not
includable in the taxpayer's
gross income. The majority of
the court reasoned that under
Alabama law, attorneys had the
same rights as their clients and
that Mrs. Cotnam could never
have received the portion paid
as attorneys' fees. This is a
case from the Fifth Circuit,
prior to the time a portion of
the circuit was split off to
form the Eleventh Circuit.
An Action on
Decision in the Cotnam case
states that the Service will not
follow the court's ruling in
future cases. The Government has
requested the full Court of
Appeals for the Eleventh Circuit
to reconsider the Cotnam
decision. In Davis v.
Commissioner, T.C. Memo.
1998-248, aff'd, 210 F.3d 1346
(11th Cir. 2000), the Tax Court
concluded it was bound by Cotnam
in cases arising under Alabama
law, and, thus, ruled adversely
to the Commissioner. However,
the Eleventh Circuit declined to
reconsider Cotnam in the Davis
appeal. Similarly, the Fifth
Circuit followed Cotnam in
reversing the Tax Court's
decision in Srivastava. The
panel agreed with the Tax
Court's rationale in Kenseth but
nevertheless, the majority of
the panel elected to follow its
precedent in Cotnam. The Service
is considering whether to
recommend to the Department of
Justice that Supreme Court
review is appropriate and
warranted.
The Court of
Appeals for the Sixth Circuit
followed Cotnam in a case
arising under the common law of
Michigan. Est. of Arthur L.
Clarks, 202 F.3d 854 (6th Cir.
2000). Reversing the judgment of
the district court, the Sixth
Circuit analogized Michigan
common law of liens to the
Alabama attorney lien statute.
Because the Service did not
believe that the Sixth Circuit
created a direct conflict with
opinions arising under other
state laws, the Service did not
recommend that the Government
file a petition for a writ of
certiorari.
Until this
issue is resolved, the Action on
Decision in Cotnam should be
followed and taxpayers should
not be allowed to net the
proceeds of the direct payment
of attorneys' fees in all cases
arising under any law other than
Alabama, Michigan, and Texas.
The Service erroneously excluded
the attorneys' fees from the
taxpayers' income in Francisco
v. United States, 85 AFTR 2d
2000-754 (E.D. Pa. 2000).
Further, in cases arising under
Alabama, Michigan and Texas law,
consult with the appropriate
local Office of Chief Counsel
for the current status of this
issue.
Deduction For
Attorneys' Fees
Generally,
individuals, as cash basis
taxpayers, may deduct attorneys'
fees in the year they are paid,
assuming the attorneys' fees
otherwise qualify as deductible.
In the majority of such cases,
the attorneys' fees are paid
pursuant to a contingent fee
arrangement once damages have
been recovered. Where the
ultimate recovery is excludable
from gross income, either in
whole or in part, the payment of
contingent attorneys' fees
allocable to exempt income are
not deductible. IRC section
265(a)(1). The question of the
timing and deductibility of
attorneys' fees paid prior to
resolution of the lawsuit on a
noncontingent fee basis requires
additional analysis that is not
practical to provide in this
guide. Examiners should consult
with the appropriate Office of
Chief Counsel for guidance.
Except in rare
cases, such as a compensatory
recovery of self-employment
income, (for example,
commissions that are reported on
Schedule C) or recovery of
capital gain income, legal fees
will be a Schedule A
miscellaneous itemized
deduction, subject to the 2
percent floor and AMT. (This, of
course, assumes that the lawsuit
proceeds have been taxed at
gross in the taxpayer's income.)
Nevertheless, the Tax Court
recently held adversely to the
Commissioner that a
self-employed individual could
deduct legal fees allocable to
the recovery of punitive damages
on Schedule C, rather than as a
miscellaneous itemized deduction
on Schedule A. Guill, 112 T.C.
325 (1999). Consequently, the
court held that the punitive
damages recovered by the
taxpayer were Schedule C income.
The Service is considering the
correctness of the court's
holding and whether an AOD will
be prepared.
See: Church v.
Commissioner, 80 T.C. 1104, 1110
(1983); and Alexander, 96-1
U.S.T.C., 50,011; and IRC
section 212.
Legal Fees
Relating to Non-Taxable Awards
or Settlements
No legal fee
deduction will be allowed for
legal fees allocable to
non-taxable awards or
settlements. IRC section 265(a).
Absent strong support to the
contrary, legal fees relating to
an award or settlement that is
partially taxable will be
allocated based on the ratio
between the taxable
award/settlement and the total
award/settlement.
See
Johnson-Waters, T.C. Memo.
1993-333; and Church, 80 T.C.
1104, 1110 (1983).
Accrued
Interest on Court Judgments
Any interest
associated with an award or
settlement is always taxable.
Aames, 94 T.C. 189 (1990);
Kovacs, 100 T.C. 124 (1993);
Brabson v. United States, 96-1
U.S.T.C. 50,038, 74 AFTR 2d 572,
73 F.3d 1040 (10th Cir. 1996).
Some states have enacted
statutes requiring defendants to
pay judgment interest in tort
actions. Where the parties
settle an appeal of a verdict,
the Service has been successful
in convincing the courts that a
portion of the proceeds should
be allocated to such interest.
Delaney, 99 F.3d 20 (1st Cir.
1996), aff'g T.C. Memo.
1995-378.
Chapter 4,
Sources of Information
Note:
The comments in this section
concerning information
sources must be used within
the guidelines for
compliance initiative
projects. Additionally, the
requirements for third party
contacts and third party
summonses outlined in RRA 98
must be followed.
Identifying
taxpayers who have received
large taxable lawsuit
settlements can be a difficult
process because a Form 1099 is
not usually issued to the
plaintiff. Most of the returns
to be examined would not
normally be selected through
regular classification. The
following sources may be used to
identify large taxable lawsuit
settlements.
Newspaper
Articles
One readily
available source of information
is local newspaper articles.
Large punitive damage verdicts
generally make headlines. A
coordinator can be responsible
for reviewing and maintaining
interesting newspaper articles.
This is an
excellent source of identifying
taxpayers that have gone to
court and had a jury verdict.
This does not identify
individuals who settle prior to
a jury verdict.
Courthouse
Research
Determine where
civil lawsuits are originally
filed in your jurisdiction. In
many states cases are filed with
the circuit clerk's civil
division at the county
courthouse where the lawsuit
originates. There may be tens of
thousands of civil cases filed
in one year. Only a small
portion of these cases will be
punitive damage cases.
Identifying punitive damage
cases from this population can
be a difficult process. Some of
the techniques used to identify
these cases include the
following:
-
Scan the
style of the case (plaintiff
versus defendant) at each
courthouse. Most of the
circuit clerks' offices will
be computerized, but some
have hand-written records.
-
Identify
insurance companies and
finance companies who are
defendants in the cases.
These are typically the
types of companies being
sued for punitive damages.
-
Record the
case file number.
-
Review the
case file. Most of the cases
are settled out of court and
dismissed with prejudice.
This means the case has
received final settlement
and cannot be further
litigated. Typically the
dollar amount of the
settlement is not noted in
the file if the case is
settled out of court. Use a
worksheet (see Appendix A
for a sample) to gather
pertinent information from
the civil case file.
Scanning the file is one of
the most important
techniques to become
familiar with the type of
lawsuit filed. Suits which
seem to have non-physical
damages (fraud, negligence,
misrepresentation, etc.) are
to be given priority.
-
Review
cases which are large in
size. This tends to indicate
that the lawsuit was in
process for an extended
period of time, and this
could be an indication of a
large settlement.
Computerized
Data
In some states
it may not be necessary to
manually research the courthouse
as described above. Determine if
your state has a centralized
agency for recording all
lawsuits filed. In some states
information is sent to an
Administrative Office of Courts
(a state agency) on a monthly
basis. This state agency should
have a compiled list of the
cases filed in counties having a
computerized system. The list
may provide information such as
the case number, style
(plaintiff versus defendant),
type of case, date settled, and
amount of damages awarded.
Once it has
been determined that your state
has a compiled listing of all
civil cases, obtain the magnetic
tape of the list for all open
exam years. There may be a
charge for this magnetic tape.
The computer audit specialist
(CAS) in your district can then
manipulate the data on the tape
to certain specifications. For
example, the CAS could make a
list of all civil cases that
were settled by jury with
specific dollar amounts
designated as compensatory and
punitive. In addition, the list
could be sorted into geographic
areas to fit post of duty
locations. This POD data can
then be reviewed for cases with
exam potential. Specific
courthouse files could be
reviewed if deemed necessary.
Settlement
Payors
This same
computerized data just discussed
can be used to identify
settlement payors. Review the
database to select those
companies that appear as
defendants most often. Insurance
companies are usually the
defendants in these cases and
are a prime source of
information for lawsuits or
payments made in lieu of a
lawsuit. A contact with the
insurance company's legal
department should be made to
establish communication with the
company. At that time you may
explain the possible tax
consequences of the payments and
what information you need.
Request that they provide you
with the information.
Third party
letters can be issued to the
settlement payors requesting
records needed to begin
examinations (see Appendix B for
sample attachment to third party
letters). However, because of
legal reasons, many insurance
companies will require that you
issue a summons to them before
they release any information to
you. Whether you are issuing a
third party letter or a summons,
the following information should
be requested:
-
Copies of
the complaint,
-
Copies of
settlement agreements and/or
waivers,
-
Copies of
front and back of checks,
-
Addresses
of the plaintiffs, and
-
Social
Security Numbers of the
plaintiffs.
When issuing a
summons, it is recommended that
you request assistance from the
company's legal department in
structuring your request for
information. This enables you to
obtain the information needed
while minimizing their efforts.
It should be
noted that the payors generally
will not have a disbursement
schedule. It is standard
practice for payors to disburse
the gross amount of the
settlement to the plaintiff's
attorney, who then disburses the
money to his or her client(s).
Therefore, the disbursement
schedule can best be obtained
from the taxpayer (plaintiff).
This information may also be
available from the plaintiff's
attorney. Generally, this
information would not be
protected by the attorney-client
privilege, but consult with the
appropriate Office of Chief
Counsel if the facts and
circumstances warrant pursuing
this action. Use of settlement
payors has advantages in that
the correct person can be easily
found. In addition, you know the
amount of the payment and the
date it was made.
See Chapter 5,
Third Party Contacts and Summons
Information, for further
information.
State
Department of Insurance
The State
Department of Insurance may have
a complaint file on insurance
companies. These files may be
reviewed for any additional
leads on punitive damage cases.
State Supreme
Court Library
The State
Supreme Court Library records
all the cases that the State
Supreme Court has heard. Many of
the large awards by jury are
appealed to the State Supreme
Court. This reference can be
used to make sure that no large
cases are omitted from possible
exam consideration.
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