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Allocating Settlements Proceeds to Produce the Best Tax Results, |
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In this day of frequent litigation, most cases settle out of court. Attorneys have a unique opportunity to provide tax planning to their clients from the onset of
litigation through the settlement process. When a case settles, the tax consequences of recovery for a claim depend on the nature of the underlying claim. When recovery is taxable, the character of
the recovery depends on the character of the underlying claim. Typically, a payment need only be reported by the payor when the claim is taxable to the recipient and in a fixed or determinable amount.
A. Personal Injuries Congress amended section 104 of the Internal Revenue Code in 1996. Now, instead of the troublesome "tort-type right" standard, personal damages are only excluded from
the recipient's gross income when they are "on account of personal physical injuries or physical sickness." Punitive damages are taxable with one exception: if they flow from a civil, wrongful death
action where the applicable state law has been in place without modification since September 13, 1995 and that state law provides or has been interpreted to provide that only punitive damages are available.
Amounts recovered on account of emotional distress generally should not be treated as amounts recovered due to a physical injury or physical sickness, but amounts recovered for payments made for medical care
attributable to emotional distress are excluded from income. Therefore, section 104 excludes only three types of payments: (1) payments received on account of personal injuries or physical sickness; (2)
payments received on account of emotional distress attributable to personal injuries or physical sickness; and (3) payments received on account of emotional distress, but only to the extent of the amount actually paid
for medical care for such emotional distress. B. Property Injuries As a general rule, recovery for damage to property is treated as a sale or exchange of that property. Payments received for damages to property will be taxable to the extent the payment exceeds the payee's basis in the property. The payee may replace or repair the property without triggering gain beyond the payee's basis by, for example, section 1033's nonrecognition provision for involuntary conversions. If gain must be recognized, the character of any gain will be determined by reference to the character of the damaged property, and payments representing a replacement of capital are taxable only to the extent that they exceed the basis of the property replaced, and then only as capital gain. C. Allocating Proceeds Generally, courts will respect an allocation made in good faith between adversarial parties. The most important factor in
determining what a payment is made for is the payor's intent. The strongest evidence of payor's intent is the parties' allocation included in the settlement. When determining the payor's intent, the payee's
understanding is of little consequence. The validity of the underlying claims will not be tested when a court examines the parties' allocation. An allocation by a jury will generally be respected. If
the parties allocate the settlement, their allocation will only be respected if they are bona fide adversaries when the allocation is made. Interest is taxable under section 61 of the Code. Courts have
construed this section to apply to both pre- and post-judgment interest. In the case of a section 104 claim, even though interest is paid with respect to tax-exempt income, the interest itself is not exempt from
tax. When allocating a settlement after an award containing pre- or post-judgment interest, a settlement that fails to take into account the award's inclusion of interest will be suspect. When the parties'
allocations do not reflect the substance of the settlement, courts will recharacterize the allocation. Settlements that make no allocation are particularly vulnerable to reallocation. For instance, when a
settlement was reached after an allocated jury verdict but the settlement itself failed to allocate the proceeds, the First Circuit reasoned in Rozpad v. Commissioner that "it is not unfair to assume, in the
absence of a contrary allocation, that [each component] compose[s] the same proportion of the settlement as of the antecedent judgment." The Tax Court and federal courts should give "proper regard"
to allocations made by state courts. Thus, a state court allocation is some evidence of the proper tax treatment of the payment, but it is not dispositive. If the Service challenges the parties' allocation,
the Service has the benefit of a presumption that its assessment is correct, thereby requiring the taxpayer to affirmatively prove, by a preponderance of the evidence, that taxes are in fact not owed. When the
parties fail to make an allocation, the court may allocate the proceeds itself. For instance, the Tax Court in Matray v. Commissioner examined the facts of the case and determined that approximately half the
settlement was attributable to a nontaxable personal injury claim and half was attributable to a taxable breach of contract claim. Other courts refuse to allocate, instead finding the entire payment taxable when
the payee makes any taxable claim. Like the analysis a court will use to determine whether or not the parties' allocation is of substance rather than form, courts will examine all relevant evidence, including the
details of the litigation which gave rise to settlement, such as the payee's complaint and the arguments made by the parties. The causes of action in the original complaint and the evidence and arguments of the
underlying proceeding, including the testimony of witnesses and the judgment, are viable pieces of evidence to establish a proper allocation. When parties settle their disputes prior to the filing of a complaint,
evidence of their informal claims, like those made in correspondence exchanged between the parties, will be relevant. To obtain the most favorable result for their client, attorneys should take care to establish the
desired allocation at each step of litigation. When possible, a complaint should include (or emphasize) section 104 type claims. Thus, in order to minimize negative tax consequences, attorneys should
attempt to establish a physical injury, even where that injury may be of relatively minor importance to the client's objectives in litigation. "Kitchen sink" complaints are particularly vulnerable
to unfavorable tax consequences, as they often allege many contract and non-physical tort claims (taxable claims). If the case eventually settles, the complaint, with its abundance of claims, will be evidence of
the appropriate tax consequences, and a court may allocate proceeds to taxable throw-away claims. This is true both with and without an allocation by the parties. If the payee signs a general release of all
claims, a court may determine that the settlement applies equally to all claims in the complaint, no matter how viable. Recall, however, that the viability of the underlying claims is weak evidence when
determining the tax consequences of a settlement. Therefore, attorneys should avoid drafting complaints that include taxable claims that are not vital to the litigation, as a throw-away non-personal injury claim
may result in apportionment to a taxable item. An attorney can also establish a factual basis for physical personal injury claims outside of the trial record. For example, an attorney should mention the
importance of a physical personal injury claim in correspondence with the opposing attorney, the client's doctors, and the client. During discovery, an attorney should be sure to take depositions and affidavits
concerning the client's injury when it is applicable. When a client has suffered physical manifestations of emotional distress, the attorney should treat these manifestations as carefully as a physical injury
in building his case in order to bring these claims securely within section 104. Particularly where the emotional distress has its origin in a physical injury, recovery of an amount for this distress may be a
vital part of a plaintiff's claim. Shuttling proceeds to the physical personal injury components of the action and away from the emotional distress claim may raise questions of over-reaching for favorable tax
consequences. Since emotional distress claims that flow from physical injuries are safely non-taxable, an attorney can emphasize these claims without inviting a tax burden. It is important that the attorney
establish a basis for the physical injury claims before settlement negotiations have significantly advanced. This is because the parties are adverse to one another only as to whether or not the payor will
ultimately pay. As the courts are acutely aware, a paying defendant has no apparent direct interest in how a settlement payment is allocated. Therefore, because an allocation must be made in an adversarial
context from arm's length, parties setting an allocation after a settlement amount has been reached may not be sufficiently adverse to support the allocation. When drafting the settlement, an attorney may spare her
client litigation with the Service if the attorney allocates some portion of the payment to non-excludable claims. An attorney may allocate an amount to each claim, or allocate one amount to the most important
(non-taxable) claim and a second amount to "any and all other claims." As an alternative, the settlement agreement could recite that only those claims receiving an allocation are valid. If a judge
oversees the settlement, the attorney should try to involve the judge in the allocation, rather than merely ask the judge to approve the allocation arranged by the parties because court approval of the parties'
settlement agreement which includes an allocation may be disregarded, unless the court also conducts an independent review. If the settlement is reached after an award from the court that includes interest, the
parties should take care to address the likelihood that the settlement will be reallocated if interest is simply ignored. The parties should allocate some amount to interest, or establish a substantive reason why
an allocation to interest is inappropriate. While a defendant does not have an apparent direct interest in allocating a portion of payments towards non-taxable claims, a defense attorney should keep in mind the
payee's tax consequences when determining what the defendant is willing to pay. The tax status of the payment has significant impact on the value of a claim. For example, supposing a flat income tax rate of
30% and no other applicable taxes, a $100,000 allocation to a taxable claim costs the defendant the full $100,000, but results in a net gain to the plaintiff of only $70,000. Were that amount allocated to a
physical injury, the defendant could provide the same net payment to plaintiff at a cost of only $70,000, resulting in a $30,000 savings to the defendant. So long as the allocation is made at arms' length during
negotiation, courts are likely to respect the tax consequences of the allocation. Parties are certainly adversarial when negotiating the amount of a settlement. Considering tax consequences in negotiation
provides the defendant an opportunity to reduce settlement costs and avoids making the government an unintended third-party beneficiary to the settlement. When litigation advances to the trial stage, an attorney may
obtain a jury instruction on the tax ramifications of a particular allocation, and in a wrongful death suit, a court's refusal to instruct the jury as to the nontaxable status of a damage award may be reversible
error. An attorney may want this type of instruction to ensure that the jury understands the true value of its award. If a complaint asks for punitive damages and none are awarded or a settlement is reached
prior to the punitive stage of the trial, both parties will want to establish that no allocation to punitive damages is appropriate. This is advisable because punitive damage awards are fully taxable to the
recipient as ordinary income, and evidence an admission of wrongdoing on the part of the payor. D. Allocating Fees and Expenses The Service and the courts are sensitive to the interaction between the
attorney's fees and expenses and the excludability of section 104 physical personal injury awards. Thus, while attorney's fees and expenses represent income to a litigant when a settlement payment for the
underlying claim is received, allocation between the portions of the client's settlement which are includable and excludable is permitted. Indeed, allocation is required if a taxpayer wishes to deduct the expenses
associated with obtaining any taxable portion of the claim. The portion of fees and expenses that are allocable under a section 104 claim cannot be deducted, but the portion of fees and expenses that are allocable
to a taxable claim can be deducted. Naturally, potential deductibility under sections 162 or 212 should be ignored in determining whether or not to report payments for attorney's fees and expenses. Please note
that the information above is provided in general terms and may or may not apply to your particular facts. |
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