TAX LAW FOR THE LITIGATOR

Transcription

1 CLE & Ski January 14, 2001 Big Sky, Montana TAX LAW FOR THE LITIGATOR RICHARD M. BASKETT Attorney - CPA Baskett Law Office Suite North Higgins Avenue Missoula, Montana (406) by Richard M. Baskett. All rights reserved.

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3 TABLE OF CONTENTS 1 Overview...1 [1] Introduction...1 [2] Guiding Tax Principles...1 [3] Origin of the Claim Test Recoveries for Injuries or Sickness...6 [1] Section 104 Exclusion In General [2] Offset for Prior Year Medical Deductions [3] Emotional Distress Recoveries...7 [4] Workers Compensation and Disability [5] Punitive Damages...13 [6] Judgment Interest Employment Related Claims...15 [1] Wage Claims...15 [2] Allocating Recoveries Between Wages and Other Amounts [3] Sex Discrimination...17 [4] Age Discrimination...18 [5] Racial Discrimination...18 [6] Wrongful Termination...19 [7] Punitive Damages...19 [8] Settlement Agreements Recoveries by Businesses...20 [1] Lost Profits vs. Goodwill...20 [2] Recovery of Capital...21 [3] Tax Benefit Rule...21 [4] Patent Infringement...22 [5] Liquidated Damages...22 [6] Involuntary Conversions...22 [7] Covenant Not To Compete Structured Settlements...23 [1] What They Are...23 [2] History...23 [3] Constructive Receipt...25 [4] Economic Benefit Doctrine...25 [5] Qualified Assignments...26 [6] Attorney Fees...28 i

4 6 Self Sufficiency Trusts...29 [1] The Problem...29 [2] Legal Authority...29 [3] Definition of Self Sufficiency Trust [4] Governmental Benefits...30 [5] Repayment of Government Benefits [6] Administration of Trust Account...31 [7] The Players Discretionary Trusts...33 [1] Distinguished from Self Sufficiency Trusts [2] Similarities to Self Sufficiency Trusts Divorce...34 [1] Property Settlements...34 [2] Maintenance Payments...42 [3] Child Support Attorney Fees...46 [1] Introduction...46 [2] Attorney Fees in a Divorce...46 [3] Alternative Minimum Tax...47 ii

5 by RICHARD M. BASKETT Attorney - CPA Baskett Law Office Suite N. Higgins Avenue Missoula, Montana (406) Overview [1] Introduction [a] Tax consequences can have a significant impact on the economic benefit of any settlement or judgment, and the failure to take them into account and advise the client can give rise to a malpractice action against the attorney. This outline by no means covers everything, but it is intended to touch on some of the highlights of tax law that might concern a litigator, particularly one practicing in Montana. This outline also includes a brief discussion of self-sufficiency trusts and discretionary trusts, which are important to a litigator with a client who is receiving government assistance. While these are not tax law concerns, they still come within the general ambit of estate planning and are included here so they are not overlooked in the course of settling a lawsuit. [b] A settlement does not differ from a judgment in determining tax consequences. More planning opportunities are available for a settlement than a judgment, but the IRS is no more bound by a judgment than a settlement in determining the tax consequences of the result. [c] There are two principal issues to keep in mind in determining the desired outcome of litigation: first, will there be income from the recovery, and, second, what will be the character of any income: ordinary or capital, and if it is ordinary, is it wages or other ordinary income? [2] Guiding Tax Principles [a] Income [i] The Internal Revenue Codes subjects to taxation gross income, which CLE & Ski

6 is defined to mean all income from whatever source derived. IRC 61. [ii] Although 61 provides a broad, general, definition of income, certain specific items of income are identified in 71 through 90 of the Internal Revenue Code. Examples of these include alimony ( 71), prizes and awards ( 74), group term life insurance for employees ( 79) and property transferred in connection with the performance of services ( 83). [iii] Exclusions from income are narrowly construed. Specific exclusions are found in 101 through 139. Examples of these include life insurance death benefits ( 101), gifts and inheritances ( 102), municipal bond interest ( 103), and, important to our discussion, compensation for sickness or injury ( 104). [b] Capital vs. Ordinary Treatment [i] The taxpayer will usually prefer to have capital gain rather than ordinary income, and ordinary loss rather than capital loss. A capital gain or loss, however, requires a sale or exchange. In Rev. Rul , the IRS ruled that settlement of a lawsuit was not a sale or exchange. Without the sale or exchange, the IRS held, the payment would be treated as ordinary income. [ii] Consequently, a payment in settlement of a dispute over a contract will be treated as ordinary income if the payment under the contract would have been ordinary income, but if the dispute is over property rights the settlement payment will be treated as capital. [c] Basis [i] Basis can be deducted from the gross proceeds received in a sale of an asset in determining the amount of taxable income. In many instances, capital gain or loss follows, but there are examples of capital transactions in which the income is ordinary, such as when the transaction involves recapture of depreciation. Even if the transaction results in ordinary income, the ability to deduct basis in determining the amount of taxable income can be a significant benefit. [ii] When taken together with the differential in income tax rates, the ability to deduct basis from the income received gives a decided advantage in most instances to capital treatment over ordinary. 2 CLE & Ski 2001

7 [d] Return of Capital TAX LAW FOR THE LITIGATOR [i] Most favorable to the taxpayer is to have the recovery treated as return of capital, since those are not subject to tax at all. This is difficult to find, but an example of this is where the recovery is related to the taxpayer s business, and the taxpayer claims the recovery is for damage done to goodwill (but this will be beneficial only to the extent the taxpayer has basis in the goodwill, which often is not the case). [ii] Contrasted to recovery of lost profits, which will be treated as ordinary income, recovery for damage to goodwill with basis is very attractive. Where the aggrieved party does have basis in goodwill, it would be wise to frame the complaint and any release in terms of recovering goodwill rather than lost profits. [iii] The test is whether all of the facts, including pleadings, evidence, and testimony, indicate that a payment was intended to compensate for loss of profits or harm to capital. Kucera v. Commissioner, TCM (P-H) 51090, 10 TCM (CCH) 303 (1951). [e] Physical Injury [i] Recovery for physical injury is exempt from tax under the specific provisions of 104 of the Internal Revenue Code. The theoretical basis of exempting damages for physical injury is that one is only being compensated for what was lost; returned to the status quo prior to the injury. The logic is the same as in the business setting where goodwill has been lost and is only be replaced by monetary compensation. [ii] The Small Business Job Protection Act of 1996 introduced the requirement that, in order to be excluded from income, the recovery had to be for personal physical injury or physical sickness. Prior to that, personal injury could be excluded, whether or not it was physical, allowing for more instances in which recoveries were not taxable. [f] Wages [i] Recovery of wages is subject to the highest of taxes. It is ordinary income, subject to employment as well as income tax. [ii] Recovery for injury incurred at the work place can have elements of CLE & Ski

8 both wage claims and physical injury. With such disparate tax treatment, the complaint and any settlement should be carefully crafted to the extent possible within the facts available. [g] Involuntary Conversions [i] Involuntary conversions receive special treatment under the Internal Revenue Code. The owner can avoid recognizing gain by replacing the property within the time specified in [ii] Involuntary conversion is property s destruction in whole or in part, theft, seizure, or requisition or condemnation or threat or imminence thereof [iii] The converted property has to be replaced with property which is similar or related in service or use. [iv] The price of non-recognition is generally carryover basis, and that is the case here. Because there is no recognition of gain, the replacement property takes the same basis as the converted property, except that the replacement property s basis is: 1) decreased in the amount of any money received by the taxpayer which was not expended in accordance with the provisions of law (applicable to the year in which such conversion was made) determining the taxable status of the gain or loss upon such conversion, and 2) increased in the amount of gain or decreased in the amount of loss to the taxpayer recognized upon such conversion. [v] The replacement period begins with whichever of the following dates is earlier: 1) The date of the disposition of the converted property, or 2) The earliest date of the threat or imminence of requisition or condemnation of the converted property. [vi] The replacement period ends: 4 CLE & Ski 2001

9 1) 2 years after the close of the first taxable year in which any part of the gain upon the conversion is realized, or 2) subject to such terms and conditions as may be specified by the Secretary, at the close of such later date as the Secretary may designate on application by the taxpayer. [3] Origin of the Claim Test [a] The taxation of any recovery will be determined by the origin of the claim. [b] The seminal case in this area is United States v. Gilmore, 372 US 39 (1963), which involved legal fees paid by an individual going through a divorce. This particular individual was the principal shareholder in a corporation that had three automobile dealerships. The fees were incurred in 1953 and 1954 which is relevant principally because had the shareholder been found guilty of infidelity it might have cost the corporation its automobile dealerships. He also was concerned with protecting his ownership interest in the corporation so that he would not be deprived of the principal means of his livelihood. Because the shareholder was tying to conserve property held for the production of income, he thought the legal fees he incurred in the divorce should be deductible, but the IRS said they were personal expenses. The Supreme Court agreed with the IRS, holding that the origin of the claim was personal in nature and so the legal fees were not deductible. Justice Harlan opined that the wife s claims stemmed from the marital relationship and not from income-producing activity and that deductibility depended on whether the claim arose in connection with the taxpayer s profit-seeking activities, not on the consequences of failing to defeat the claim. [c] The Court reasoned that it could not look to the nature of the assets out of which the judgment would be satisfied to determine deductibility of the legal expenses, using this example: If two taxpayers are each sued for an automobile accident while driving for pleasure, deductibility of their litigation costs would turn on the mere circumstance of the character of the assets each happened to possess, that is, whether the judgments against them stood to be satisfied out of income- or non-income-producing property. [d] The Court stated the rule this way: [T]he origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of CLE & Ski

10 whether the expense was business or personal and hence whether it is deductible or not Recoveries for Injuries or Sickness [1] Section 104 Exclusion In General [a] Section 104 of the Internal Revenue Code provides a specific statutory exclusion from the general rule that all income is taxable. [b] The statutory exclusion overrides the origin of the claim test. Even though some portion of a personal injury recovery might relate to backpay, 104 excludes it from income. [c] The significant change made to 104 in 1996 was that it was amended to exclude recoveries only for physical rather than personal injuries. [d] Section 104 now provides an exclusion for: [i] amounts received under workmen's compensation acts as compensation for personal injuries or sickness; [ii] 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; [iii] amounts received through accident or health insurance (or through an arrangement having the effect of accident or health insurance) for personal injuries or sickness (other than amounts received by an employee, to the extent such amounts (A) are attributable to contributions by the employer which were not includable in the gross income of the employee, or (B) are paid by the employer); [iv] amounts received as a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country or in the Coast and Geodetic Survey or the Public Health Service, or as a disability annuity payable under the provisions of 808 of the Foreign Service Act of 1980; and [v] amounts received by an individual as disability income attributable to injuries incurred as a direct result of a violent attack which the Secretary 6 CLE & Ski 2001

11 of State determines to be a terrorist attack and which occurred while such individual was an employee of the United States engaged in the performance of his official duties outside the United States. [2] Offset for Prior Year Medical Deductions [a] The 104 exclusion does not apply to any recovery of medical expenses deducted in a prior year. The taxpayer has already received the benefit of the tax deduction, so Congress is not going to allow the recovery to be excluded from income. [b] But remember only medical expenses in excess of 7.5% of adjusted gross income can be deducted, and then only if the taxpayer itemizes deductions, so to the extent the taxpayer recovers medical expenses up to 7.5% of that prior year s AGI, the exclusion does apply. [c] The IRS will presume that the first amounts recovered are allocable to medical expenses, but this presumption can be overcome by an express allocation in a settlement agreement, unless it is unreasonable in the light of all the facts. Rev. Rul , C.B. 93 (1975). [d] Recovery of future medical expenses is non-taxable, but then when the expenses are actually incurred, they cannot be deducted, at least until they exceed the total amount recovered. It is best to allocate the amount attributable to future medical expenses in the settlement agreement, but even when the recovery is in a lump sum an allocation of a portion of the recovery to future medical expenses has been upheld when the amount can be determined with reasonable certainty. Niles v. United States, 520 F.Supp. 808, 81-2 U.S. Tax Cas. (CCH) (N.D. Cal. 1981); aff d, 710 F.2d 1391, 83-2 U.S. Tax Cas. (CCH) 9477, 52 th A.F.T.R.2d (P-H) (9 Cir. Cal. 1983). [3] Emotional Distress Recoveries [a] Emotional distress recoveries, absent physical injury, are includable in income, except to the extent of the amount paid for medical care attributable to emotional distress. [b] The Small Business Job Protection Act of 1996 amended 104 to specifically address emotional distress. 104 now states that, emotional distress shall not be treated as a physical injury or physical sickness and consequently the exclusion under 104(a)(2) for personal physical injuries or physical sickness CLE & Ski

12 does not apply. [c] As amended, however, 104 does permit an exclusion for damages not in excess of the amount paid for medical care attributable to emotional distress. [d] Physical symptoms resulting from emotional distress, such as insomnia, headaches or stomach disorders, are included within the meaning of emotional distress, according to the Conference Committee Report. [e] Punitive damages, however, are not excludable even when they arise out of a claim based on physical injury or physical sickness. [f] On the other hand, amounts recovered for emotional distress resulting from physical injury are excludable. [g] The changes made by the Small Business Job Protection Act of 1996 are effective for recoveries received after August 20, 1996, but a grandfather provision is included for written binding agreements, court decrees, or mediation awards as of September 13, [h] The Conference Committee Report states that if a recovery has its origin in a claim of physical injury or physical sickness, then all amounts received other than punitive damages are excludable under 104(a)(2). The Conference Committee Report includes as an example of this a recovery for loss of consortium due to physical injury or physical sickness of that person s spouse. A claim for wrongful death would also be excluded. Note that in both of these example, the person excluding the income is not the one who suffered the physical injury or physical sickness. [4] Workers Compensation and Disability [a] 104(a)(1) Exclusion [i] 104(a)(1) excludes from income amounts received under: 1) workmen's compensation acts as compensation for personal injuries or sickness; or 2) a statute in the nature of a workmen's compensation act which provides compensation to employees for personal injuries or sickness incurred in the course of employment. 8 CLE & Ski 2001

13 [ii] This exclusion applies not only to the worker, but to amounts received by the survivor or survivors of a deceased employee. [iii] The 104(a)(1) exclusion does not apply to: 1) amounts which are received as compensation for a non-occupational injury or sickness nor to amounts received as compensation for an occupational injury or sickness to the extent that they are in excess of the amount provided in the applicable workmen's compensation act or acts; and 2) 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 or sickness. Reg [iv] Distinguish retirement benefits from permanent disability benefits. The latter are excludable; the former are not. 1) In Letter Ruling , the IRS ruled that a disabled police officer could exclude disability benefits equal to two-thirds of his annual compensation from gross income, but amounts greater than two-thirds that were attributable to prior contributions were includable in gross income. a) The city had approved accidental disability retirement for a police officer injured in the line of duty. The statute authorizing the disability retirement provided for payment of twothirds of the injured employee's annual compensation for which contributions were being made at the time of the injury regardless of the employee's age, length of service, or prior contributions. b) The Service concluded that because the statute was in the nature of a workmen's compensation act and the payments were payable regardless of age, length of service, or prior contributions, amounts equal to two-thirds of the police officer's compensation were excludable from gross income under 104(a)(1). Amounts greater than two-thirds of his annual compensation that were attributable to his prior CLE & Ski

14 contributions, however, were includable in gross income. th 2) In Wiedmaier v. Comm r, (US 6 Cir. 1985), payments were determined to be in the nature of retirement benefits rather than disability benefits and so were taxable. a) Robert Wiedmaier worked for the city of Detroit as a firefighter, and was injured in the line of duty by an air tank explosion. He received disability benefits, which he excluded from his income under 104, from 1976 to In 1978, because he would have accumulated 25 years of service had he remained at work, his benefits were reduced. b) The Sixth Circuit determined that amounts received after what would have been 25 years of service were taxable as in pension benefits which are includable in income. [v] In order to be excluded, the payment has to be due to an injury or illness that is work-related. 1) In Letter Ruling , the Service ruled that benefits paid to policemen and firemen under a state plan weren't excludable from income under 104(a)(1) because the benefits were not limited to employees suffering on-the-job injury or sickness or were not in the nature of a workers' compensation act. 2) In Kane v. U.S., 95-1 USTC 50,060, 75 AFTR2d , 43 F3d 1446, a federal district court judge claimed exclusion of amounts he received in the form of disability retirement pay, after he was diagnosed with sleep apnea, which was stress induced. a) The United States Court of Appeals for the Federal Circuit said the statute under which the payments were made was not in the nature of a workmen s compensation act because it was not a substitute for employer liability. It provides for a continuation of salary... [and] does not in any way displace or relieve the government from any employer liability to the extent that the disability might be work related. b) In addition, the Court said, the statute was not in the nature of a workmen's compensation act, rejecting the retired judge s 10 CLE & Ski 2001

15 position that the exclusion was allowable if the taxpayer's payments were triggered by a work-related injury. Judge Lourie stated that the lower court properly focused on the "face of the statute," i.e., 372(a). Again referring to reg (b), Judge Lourie wrote that "it is the STATUTE, not the nature of the INJURY, that must be analyzed to determine whether it is the nature of a workmen's compensation act." c) Furthermore, the court said the payments could not be excluded because the statute did not take the nature of the injury into consideration. [b] Military Disability Retirement Pay - 104(a)(4) [i] 104(a)(4) excludes from income amounts received: 1) as a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country or in the Coast and Geodetic Survey or the Public Health Service, or 2) as a disability annuity payable under the provisions of 808 of the Foreign Service Act of [ii] The exclusion only applies if one of four qualifications are met: 1) on or before September 24, 1975, the recipient was entitled to receive such payments; 2) on September 24, 1975, the recipient was a member of any organization (or reserve component thereof) referred to in 104(a)(4) or under a binding written commitment to become such a member, 3) the recipient receives such a payment by reason of a combat-related injury, or 4) on application therefor, the recipient would be entitled to receive disability compensation from the Veterans' Administration. [c] Accident and Health Insurance CLE & Ski

16 [i] Amounts received through accident or health insurance for personal injuries or sickness are excludable under 104(a)(3). [ii] If, however, the employer made contributions to the plan which were not included in the income of the employee, the amounts received are taxable income. [iii] The same rule applies to amounts paid directly by the employer. [iv] A disability plan that is funded by an employer or by insurance paid for by the employer results in taxable benefits. Reg (d). [v] Although amounts paid by or on behalf of an employer to an employee for personal injuries or sickness are not excludable from the employee's gross income under 104(a)(3), they may be excludable therefrom under 105, which excludes from income amounts paid directly or indirectly to reimburse the employee for medical care. Reg (d). [d] Old Case Law [i] Beware cases pre-dating the 1996 amendments holding income to be excludable. These cases often do not include components of injury or sickness that are physical, and therefore would not come within the exclusion of 104(a)(2). [ii] Examples of such cases include: 1) Libel and slander 2) Alienation of affections 3) Violations of constitutional rights [iii] Wrongful death recoveries may or may not be excludable. 1) In general, the IRS has treated amounts paid under a wrongful death statute as non-taxable. 2) But if the wrongful death statute provides exclusively for the recovery of punitive damages, with no amount recoverable as compensatory damages, the IRS has treated it as taxable. In Rev. 12 CLE & Ski 2001

17 Rul , the IRS held that amounts received by a surviving spouse and child in consideration of the release from liability under a wrongful death act, which provided exclusively for payment of punitive damages, were includable in their gross incomes. 3) At least one federal district court rejected the IRS approach, even though the wrongful death statute provided that all recoveries were punitive damages, on the grounds that it was illogical the wrongful death proceeds were not received because of physical injuries. Burford v. United States, 642 F.Supp. 635, 86-2 USTC 9724, 58 AFTR2d (N.D. Ala. 1986). 4) As amended in 1996, 104 now provides that if the statute treats all wrongful death recoveries as punitive damages, the recovery shall nonetheless be excludable. [5] Punitive Damages a) Remember, in general, because of the 1996 amendments, punitive damages are always taxable. b) This exception to the rule taxing punitive damages is grandfathered in. The wrongful death statute has to have been in effect on September 13, c) The statute must explicitly provide, or have 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. d) This grandfathered exception shall cease to apply to any civil action filed on or after the first date on which the applicable State law ceases to provide (or is no longer construed to provide) that only punitive damages may be awarded in such an action. [a] In general, punitive damages are taxed as ordinary income. The Small Business Job Protection Act of 1996 clarified that punitive damages related to personal injury claims are taxable. This brought a degree of certainty to an area that previously was somewhat unsettled. CLE & Ski

18 [b] The difficulty comes in determining what portion of a recovery is punitive damages when, as is often the case, a judgment is appealed and then settled on appeal. [c] The inclination of both sides is not to treat any portion of the settlement as punitive damages, since the plaintiff would have to report all of it as ordinary income and the defendant does not wish the bad publicity of having been punished. The IRS is more likely to abide by agreements in which the parties have competing interests, but the parties are not at opposite poles with punitive damages. [d] Example: A jury verdict of $500,000 compensatory damages and $500,000 punitive damages is settled on appeal for $750,000. The issue then becomes: what portion of the settlement is compensatory damages and what portion punitive? It is not necessarily pro rata, nor is it necessarily governed by the agreement of the parties, but having the agreement in place breaking down the amounts of the settlement is nonetheless better than leaving it to later determination by the IRS. [e] In Rev. Rul , C.B. 18, a taxpayer received an amount in settlement of a libel suit in which the taxpayer had asked for both compensatory and punitive damages. Because of the lack of adjudication, the amount was not distinguished as to the portions allocable to satisfaction of the taxpayer's claim for compensatory damages as distinguished from the taxpayer's claim for punitive damages. The revenue ruling concludes that, inasmuch as the tax consequences attributable to each claim differ, allocation is necessary and proper and that the best evidence available under the facts and circumstances of the case to determine a proper allocation was the taxpayer's complaint. This Revenue Ruling, however, was superseded by Rev. Rul , discussed below. [f] In Rev. Rul , C.B. 93, a taxpayer received an amount in settlement of a personal injury suit. In determining what part of the settlement amount was allocable to medical expenses incurred and deducted under 213 of the Code in a prior year, the revenue ruling states that Rev. Rul provides a method of allocation, with respect to settlement of a libel suit, that is based on the best evidence available under the circumstances, which, in Rev. Rul , was the relative percentages of the amounts alleged in the complaint. Rev. Rul distinguishes Rev. Rul based on a conclusion that the best evidence available on which to base an allocation under the facts and circumstances of Rev. Rul is the amount of previously paid medical expenses, which is a sum certain, in contrast with the generally speculative nature of the 14 CLE & Ski 2001

19 pain and suffering damages alleged in a personal injury suit. [g] In Rev. Rul , plaintiff sued for defamation. The complaint asked for compensatory damages of 15x dollars and punitive damages of 45x dollars. The amount of compensatory damages requested relative to the amount of punitive damages request, 1 to 3, bore a reasonable relationship to what a jury might be expected to award under the facts and circumstances of the case. Shortly before trial, the taxpayer and the defendant agreed to a settlement of the libel suit. The taxpayer received a lump-sum payment of 24x dollars in full settlement of all the taxpayer's claims. The IRS determined that the best evidence available to determine a proper allocation was the taxpayer's complaint, since the amount of punitive damages relative to compensatory damages requested bore a reasonable relationship to what a jury might be expected to award. [6] Judgment Interest [a] If payments on a personal injury recovery are paid over a period of years, a portion of the payments might arguably be treated as interest. [b] Settlement agreements have been reached in which payments over extended time periods were considered not to have an interest element. [c] On the other hand, post-judgment interest will not be excludable from income. [d] Though it has not been completely settled, the IRS is likely to argue that pre-judgment interest cannot be excluded under 104. On the other hand, it might also be argued that any statutory allowance of pre-judgment interest is part of the damages recovered and therefore excludable. A settlement agreement addressing this issue should probably refer to damages for delay rather than prejudgment interest. 3 Employment Related Claims [1] Wage Claims [a] Amounts recovered for back pay will be subject not only to income tax but to employment tax as well. [i] Such recoveries will be subject to withholding. CLE & Ski

20 [ii] An issue may arise as to the years for which the back pay is taxable. The claim may relate to prior years, with a settlement reached or judgment awarded in a subsequent year, and the amount collected in still another year. The Sixth Circuit has held that back pay was subject to FICA taxes in the years to which the back pay relates. Bowman v. U.S., 824 F.2d 528, 87-2 th USTC 9544, 60 AFTR2d (6 Cir. 1987). [b] Recoveries based on employment but sounding in tort, such as wrongful termination, may not be treated as wages, and so may not be subject to withholding. For example, in Lisac v. United Airlines, 10 Cal. App. 4th 1500, 11 Cal. Rptr. 2d 689 (6th Dist. 1992), the court said withholding was not required on a damage award for breach of contract and various torts, including wrongful termination and intentional infliction of emotional distress. [2] Allocating Recoveries Between Wages and Other Amounts [a] Under the 1996 amendments, there is an incentive to allocate recoveries to claims arising out of physical injuries, because then all amounts recovered are tax-free even if they contain elements of emotional distress and other nonphysical recovery. [b] Where the recovery is taxable, a second-level allocation becomes important, and that is the allocation between wage and non-wage portions. The amount allocated to wages will be subject to income and employment taxes while the non-wage portion will be subject only to income tax. [c] In settling a case, the defendant employer is most likely going to want certainty as to the treatment of the amount paid, so as not to be subject to further liability to the IRS for failure to withhold. If part of the settlement or judgment is for wages and part for emotional distress or other non-wage items, the IRS may question the allocation. [d] The regulations provide that: [i] The term wages means all remuneration for employment unless specifically excepted. Reg (a)-1(b). [ii] The name by which the remuneration for employment is designated is immaterial. Reg (a)-1(c). [iii] Remuneration for employment, unless such remuneration is 16 CLE & Ski 2001

21 specifically excepted, constitutes wages even though at the time paid the relationship of employer and employee no longer exists between the person in whose employ the services were performed and the individual who performed them. Reg (a)-1(i). [e] Consequently, the employer-defendant is going to feel there is a strong case for excluding the recovery from classification as wages before agreeing to a settlement allocating part of an otherwise taxable recovery to a non-wage classification. This concern presumably applies only to settlement agreements, since under a judgment the defendant is ordered to pay amounts as specified by the court. [3] Sex Discrimination [a] Damages for intentional discrimination under Title VII of the Civil Rights Act of 1964 are taxable. Rev. Rul , C.B. 6. [b] In United States v. Burke, 504 U.S. 229 (1992), the Supreme Court held that back pay received for disparate impact gender discrimination under Title VII was not excludable from gross income as damages received on account of personal injuries under former 104(a)(2) because that part of Title VII did not compensate for a broad range of traditional tort harms. Burke interpreted Title VII as it existed prior to amendment by the Civil Rights Act of The Supreme Court seemed to imply that recoveries under Title VII after 1991 would be excludable. [c] In light of Burke, the Service issued Rev. Rul , C.B. 61, which holds that compensatory damages and back pay are excludable from gross income as damages for personal injury under former 104(a)(2) when received for: (1) disparate treatment gender discrimination under Title VII, as amended in 1991; (2) racial discrimination under 16 of the Civil Rights Act of 1870, 42 U.S.C and Title VII; and (3) disparate treatment discrimination under the Americans With Disabilities Act, 42 U.S.C. sections , as amended in All three of these statutes provide a broad range of compensatory damages of the type the Supreme Court focused upon in Burke. [d] In Commissioner v. Schleier, 115 S.Ct (1995), the Supreme Court held that back pay and liquidated damages received to settle a claim under the Age Discrimination in Employment Act of 1967, 29 U.S.C. sections (ADEA), are not excludable from gross income under former 104(a)(2). The Court concluded that former 104(a)(2) and its regulations set forth two CLE & Ski

22 requirements for a recovery to be excludable from gross 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 does not compensate for any of the other traditional tort 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. [e] Based on Schleier, the Service issued Rev. Rul , which held that 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 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 104(a)(2), except to the extent they are damages paid for medical care (as described in 213(d)(1)(A) or (B)) attributable to emotional distress. [f] Sex discrimination claims must be distinguished from sexual harassment claims, since the latter can involve a physical injury, the recovery for which is excludable under 104. The extent of injury required to invoke 104 remains to be explored. Is a physical touching enough? Is emotional distress arising out of a physical touching excludable? [4] Age Discrimination [a] As with employment discrimination, recoveries for age discrimination are taxable income. [b] The Schleier decision held that recoveries for claims brought under the ADEA were taxable, but there was still some debate about whether recoveries under state statutes could be excluded. [c] With the amendments of the 1996 Small Business Job Protection Act, the rule is now clear that recoveries for age discrimination will be taxable income. [5] Racial Discrimination [a] Because exclusion under 104 now requires that any personal injury be physical in order to be excluded from taxation, the exclusion is not available for 18 CLE & Ski 2001

23 recoveries based on claims of racial discrimination brought under Title VII. [b] If, however, the racial discrimination is manifested by a physical attack or some other physical injury, presumably the exclusion of 104 would apply to all amounts recovered. [6] Wrongful Termination [a] The garden variety wrongful termination case will result in a taxable recovery, because 104 as interpreted by Schleier requires a physical injury or physical sickness. [b] The important issue will likely be the allocation of any recovery to nonwage claims rather than wage claims, so that the amount recovered will not be subject to employment taxes and withholding. [7] Punitive Damages [a] All punitive damage recoveries are taxable. [b] Prior to 1996, some punitive damage awards were non-taxable, but the amendments to 104 made by the 1996 Small Business Job Protection Act and the United States Supreme Court decision in O Gilvie v. United States, 117 Supreme Court 452 (1996) resolved the treatment of punitive damage awards, making all of them taxable. [c] Some uncertainty remains, however, in distinguishing compensatory damages from punitive damages. th [i] In Bagley v. Commissioner, 80 AFTR2d (8 Cir. 1997), a former employee sued his former employer for tortious interference with current and future employment, libel and invasion of privacy, and was awarded a jury verdict of $1.5 million in compensatory damages and $7.25 million in punitive damages. The trial court reversed the libel claim and remanded for a new trial. Before the new trial, a settlement was reached for $1.5 million. [ii] Bagley treated all of it as non-taxable, the IRS said $1.3 million was taxable, and the Tax Court said $500,000 was taxable as punitive damages and the rest non-taxable. The Eighth Circuit affirmed the Tax Court. CLE & Ski

24 [iii] The lessons are, first, that there can be uncertainty over how much is attributable to punitive damages, second, the settlement agreement should be specific in its allocations, and third, the courts do not necessarily require a pro rata allocation of damages. [d] One benefit of punitive damages is that they presumably are not wages and consequently are not subject to employment taxes and withholding. [8] Settlement Agreements [a] In general, settlement agreements should contain an allocation between taxable and non-taxable recoveries, and as to the taxable recoveries, between wage items and non-wage items. [b] They should also obligate both parties to consistently treat recoveries on their income tax returns. If the defendant is deducting the payment as wages and the plaintiff is claiming an exclusion of the payment as arising out of physical injury, the IRS may well argue the defendant s treatment reveals the true intent of the parties. Consequently, the agreement should specify whether 1099's will be filed (or not filed) and for what items and amounts. [c] The settlement agreement should contain an indemnification from the plaintiff to the defendant if there is any question as to whether withholding is required, which would be the case where a recovery included amounts that might be classified as wages. The employer does not want to have to go back to court to obtain a satisfaction of judgment where the employee has refused to execute one because the defendant withheld taxes, so the settlement agreement should specify what is going to occur with regard to withholding. [d] The IRS will give some weight to settlement agreements, but is not bound by them. Consequently, the settlement agreement should, to the extent possible, contain evidence to back up the allocation made by the parties; a private findings of fact and conclusions of law of sorts. Reference might be made to depositions, interrogatories, medical bills and whatever else might support an allocation the parties are trying to achieve. [e] If the settlement agreement contains a gag clause, it should not be so restrictive as to prevent the parties from making disclosure of the terms of the settlement to the IRS or in judicial proceedings. 20 CLE & Ski 2001

25 4 Recoveries by Businesses [1] Lost Profits vs. Goodwill TAX LAW FOR THE LITIGATOR [a] Recoveries for lost profits are taxable as ordinary income. Had the profits been earned in the normal course of business, they would have resulted in ordinary income, so under the origin of the claim test, the recovery will be given the same treatment. [b] Recoveries for damage to goodwill are taxable as capital transactions: basis is deducted from the recovery in determining the amount subject to tax and that amount is taxed at capital gain rates. [2] Recovery of Capital [a] If the recovery can be classified as a return of capital, there will be no income tax. [i] In Rev. Rul , C.B. 433, a homeowners association was awarded a judgment against the builder of a condominium development for defects in construction of the common elements of the development. The award represented a recovery of capital that reduced the individual unit owners' bases in their respective property interests in the development, but they did not have to pay income tax on the recovery. [ii] In Rev. Rul , C.B. 366, the Service, relying on a series of cases that included Raytheon Production Corp. v. Commissioner, 144 F.2d 110 (1st Cir. 1944), cert. denied, 323 U.S. 779 (1944), stated It is well established that a sum received in settlement based upon a claim of loss of business profits constitutes taxable income but where the settlement represents damage for lost capital rather than for lost profit, the money received may be a return of capital. [b] When the recovery exceeds basis, the excess will be taxable, though as a capital transaction. [3] Tax Benefit Rule [a] Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed. IRC 111(a). CLE & Ski

26 [b] The amount had to actually have been deductible in the prior year. Personal expenditures, for example, would not qualify, because they are not deductible in the first place. But if a taxpayer suffers a loss on a bad debt, for example, which is not fully deductible, then to the extent it was not deductible, if the taxpayer subsequently recovers the debt, it will not result in income. [4] Patent Infringement [a] Patent infringement recoveries generally will result in ordinary income. [5] Liquidated Damages [a] Liquidated damages paid under a contract provision generally will result in ordinary income, even though the underlying asset to which the contract relates is capital in nature, such as stock or real estate. [b] The seller in such situations retains the underlying asset, so the receipt of liquidated damages is ordinary. [6] Involuntary Conversions [a] Involuntary conversions are non-taxable events under If the taxpayer uses the amount recovered to replace property taken in an involuntary conversion and otherwise meets the requirements of 1033, there will be no taxable event. [b] The involuntary conversion has to be as a result of property s destruction in whole or in part, theft, seizure, or requisition or condemnation or threat or imminence thereof. 1033(a). [c] The property has to be converted into property similar or related in service or use to the property so converted. 1033(a)(1). [d] If money or non-related property is acquired, the taxpayer still has a two year period in which to acquire related-use replacement property, and that can be done either directly or by acquiring controlling stock of a corporation that has such property. 1033(a)(2). [7] Covenant Not To Compete [a] The recovery for breach of a covenant not to compete has been treated as 22 CLE & Ski 2001

27 capital gain rather than ordinary income where the covenant was non-severable and was taken to insure the beneficial enjoyment of the goodwill purchased with the business. State Fish Corp. v. Comm r, 48 T.C. 465 (1967). [b] In State Fish Corp., since the element of damages was not characterized by the verdict or judgment, its character was determined by the court from the allegations of the pleading or complaint together with the issues and evidence which were presented at that trial which demonstrated that the element of lost profits was not there an independent basis for recovery but only an evidential factor in determining the actual damage to and diminution in value of the goodwill and therefore not taxable since not in excess of basis. [c] With other facts, recovery for breach of a covenant not to compete could be found to be ordinary income, especially where the recovery amount is measured by lost profits. 5 Structured Settlements [1] What They Are [a] Structured settlements are a means of settling law suits with periodic payments rather than a lump sum payment. [b] The benefit to the plaintiff is that a larger amount will be paid over the life of the plan than with a lump sum payment. The benefit to the defendant is that the up front cost of the settlement will be less than with a lump sum payment. [c] Structured settlements are considered usually only where the underlying recovery is tax-free, as in the case of amounts recovered under 104 for personal physical injury. [d] The plaintiff must not either have constructive receipt of the recovery or have receipt under the economic benefit doctrine. [2] History [a] The tax treatment of structured settlements was firmly established by the issuance of three Revenue Rulings in 1977 and [i] In Rev. Rul , C.B. 214, the U.S. was considered the CLE & Ski

28 owner of a trust established as a result of an individual's suit for injuries sustained at a Government facility under a settlement agreement requiring payment of the individual's future medical expenses from the trust, accumulation of net income in excess of medical expenses, and reversion of trust corpus to the U.S. on the individual's death. Income earned by the trust will not be subject to tax. Distributions from the trust to pay medical expenses were held excludable from the individual's gross income and no deduction could be taken for medical expenses paid by such distributions. [ii] In Rev. Rul , C.B. 74, an insurance company purchased and retained exclusive ownership in a single premium annuity contract to fund monthly payments stipulated in settlement of a damage suit. The recipient was allowed to exclude the full amount of the payments from gross income under 104(a)(2) rather than the discounted present value. Payments made to the estate after the recipient's death were also fully excludable. [iii] In Rev. Rul , C.B. 75, a taxpayer received payments for personal injury in settlement with an insurance company as a result of an accident. The insurance company agreed to make fifty consecutive annual payments, each of which would be increased by five percent a year. The entire amount of the payments received was excludable from gross income under 104(a)(2). [b] These three Revenue Rulings were subsequently codified by the Periodic Payment Settlement Act of 1982, which amended the Internal Revenue Code. [i] That Act did not define what a periodic payment was, but the legislative history did provide that a periodic payment was not an arrangement in which the plaintiff has either constructive receipt of the payments or has receipt under the economic benefit doctrine. See H. Rep. No , th th 97 Cong., 2d Sess. 4 (1982); S. Rep. No , 97 Cong. 2d Sess. 4 (1982). [ii] If a structured settlement providing for periodic payments to the plaintiff falls within the constructive receipt or economic benefit doctrine, the present value of the payments will still be excludable from income (assuming the underlying recovery would be excludable from income if received in a lump sum), but the payments in excess of the present value would be taxable, in effect representing interest being paid. 24 CLE & Ski 2001