TAX LAW FOR THE LITIGATOR UPDATE

Transcription

1 CLE & Ski January 14, 2002 Big Sky, Montana TAX LAW FOR THE LITIGATOR UPDATE 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 [a] Income...1 [b] Capital vs. Ordinary Treatment [c] Basis...2 [d] Return of Capital...2 [e] Physical Injury...2 [f] Wages...3 [g] Involuntary Conversions...3 [3] Origin of the Claim Test Recoveries for Injuries or Sickness...5 [1] Section 104 Exclusion In General [2] Offset for Prior Year Medical Deductions [3] Emotional Distress Recoveries...6 [4] Workers Compensation and Disability [a] 104(a)(1) Exclusion...7 [b] Not Retirement or Compensation for Non-Occupational Injury.. 8 [c] Military Disability Retirement Pay - 104(a)(4) [d] Accident and Health Insurance [e] Old Case Law...12 [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...16 [4] Age Discrimination...18 [5] Racial Discrimination...18 [6] Wrongful Termination...18 [7] Punitive Damages...18 [8] Settlement Agreements Recoveries by Businesses...20 [1] Lost Profits vs. Goodwill...20 [2] Recovery of Capital...20 [3] Tax Benefit Rule...21 [4] Patent Infringement...21 i

4 [5] Liquidated Damages...21 [6] Involuntary Conversions...21 [7] Covenant Not To Compete Structured Settlements...22 [1] What They Are...22 [2] History...23 [3] Constructive Receipt...24 [4] Economic Benefit Doctrine...24 [5] Qualified Assignments...25 [6] Attorney Fees Self Sufficiency Trusts...28 [1] The Problem...28 [2] Legal Authority...28 [3] Definition of Self Sufficiency Trust [4] Governmental Benefits...29 [5] Repayment of Government Benefits [6] Administration of Trust Account...30 [7] The Players...31 [a] Developmental Disabilities Planning and Advisory Council [b] P.L.U.K [c] Davidson Trust Co Discretionary Trusts...32 [1] Distinguished from Self Sufficiency Trusts [2] Similarities to Self Sufficiency Trusts Divorce...32 [1] Property Settlements...32 [a] Statutory Provisions...32 [b] Installment Contracts...35 [c] Corporate Stock...36 [d] Partnerships / LLC s...37 [e] Retirement Benefits...38 [2] Maintenance Payments...40 [3] Child Support Attorney Fees...44 [1] Introduction...44 [2] Attorney Fees in a Divorce...44 [3] Alternative Minimum Tax...45 ii

5 by RICHARD M. BASKETT Attorney - CPA Baskett Law Office Suite N. Higgins Avenue Missoula, Montana (406) Introduction At last year s CLE & Ski, I provided a broad overview of tax law for the litigator. This year, I will examine some of the developments in this area. 2. Recoveries for Injuries or Sickness [1] Section 104 Exclusion In General Section 104 of the Internal Revenue Code provides a specific statutory exclusion from the general rule that all income is taxable. 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. 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. Section 104 now provides an exclusion for: (1) amounts received under workmen's compensation acts as compensation for personal injuries or sickness; (2) 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; (3) amounts received through accident or health insurance (or through an arrangement having the effect of accident or health insurance) for personal CLE & Ski

6 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); (4) 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 (5) amounts received by an individual as disability income attributable to injuries incurred as a direct result of a violent attack which the Secretary 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. [a] Exclusion for Physical Injury - 104(a)(2) [i] Survival Actions / Wrongful Death / Loss of Consortium 1) LT In LTR , the Service ruled that payments a wife received in settlement of a survival action, a wrongful death action, and a loss of consortium claim on behalf of her husband who died from cancer associated with asbestos fiber inhalation were excludable from gross income under section 104(a)(2). After the husband, a sheetrocker, was diagnosed with cancer associated with asbestos fiber inhalation, the husband and wife filed a class action against the manufacturers and other defendants in state court. The complaint sought recovery of compensatory and punitive damages for personal injuries, and the loss of consortium. After the husband died, the wife amended the complaint. The manufacturers settled the case, and the wife received economic and noneconomic damages from the survival action, the wrongful death action, and the loss of consortium. The Service determined that because the diseases were the proximate cause of the circumstances giving rise to the wife's claims, there was a "direct link" between the physical injuries and the damages recovered. Thus, the Service concluded that the wife may exclude the damages from income. [ii] Observable Bodily Harm - LTR In LTR , the Service ruled that the damages a couple received under a 2 CLE & Ski 2002

7 settlement agreement with the wife's employer allocable to her employer's unwanted physical contacts without any "observable bodily harm" were not received on account of personal physical injuries and were includable in gross income under section 104(a)(2), but the damages received for pain, suffering, emotional distress, and reimbursement of medical expenses allocable to the period beginning with the first physical injury were excludable. Damages the couple received under the settlement agreement for punitive damages, however, were includable in gross income under 61. The wife was employed as a full-time driver. Shortly after she began her employment, her employer began making suggestive and lewd remarks to her. Her employer also began physically touching her, but those contacts did not leave any "observable bodily harm." While she was on a road trip with him, he physically assaulted her, causing her extreme pain. Her employer assaulted her on other occasions, causing physical injury. He later physically and sexually assaulted her. She then quit and filed a suit asserting sex discrimination and reprisal, battery, and intentional infliction of emotional distress. The complaint also requested leave to amend to add a claim for punitive damages for her common law claims. The employer settled the case, but the settlement agreement didn't allocate the proceeds to any of the claims. The Service concluded that the damages she received for her employer's unwanted physical contacts without any observable bodily harm were not received on account of personal physical injuries or physical sickness under section 104(a)(2), and would be includable in income. The damages received for pain, suffering, emotional distress, and reimbursement of medical expenses after the first assault, however, would be excludable because they were attributable to and linked to physical injuries. [iii] Requirement of Action Sounding in Tort - Taylor v. Comm r In Taylor v. Comm r, 246 F.3d 676 (C.A.9, 2000), the Ninth Circuit upheld a Tax Court decision denying exclusion under 104(a)(2) because the taxpayer did not establish that the settlement payment was based upon tort or tort type rights. One half of post-judgment interest on damages award, which taxpayer agreed after judgment to pay her attorneys as additional contingency fee to defend judgment on appeal, was not gross income includable on taxpayer's return, where monies became available and were payable only because attorneys were successful in defending judgment; pre-appeal agreement was analogous to a pretrial contingency fee agreement, rather than assignment of income. Foster v. U.S., C.A.11 (Ala.) 2001, 249 F.3d CLE & Ski

8 Punitive damages awarded taxpayer under Alabama law in connection with mental anguish claim were not excludable from gross income. Foster v. U.S., C.A.11 (Ala.) 2001, 249 F.3d In Holland v. U.S., 87 AFTR2d Par , the Fifth Circuit, in an unpublished per curiam opinion affirming the district court, held that under a settlement Esme Holland reserved all claims for personal injuries and thus, her proceeds not excludable under section 104(a)(2) and were taxable income. Holland received money as part of a contract with Phillips 66 Co. for noxious emissions from its refinery. Holland reported the money in Later, she filed an amended return seeking a refund of $305,108, claiming that the money she received was compensation for the relinquishment of personal tort rights against Phillips and not taxable as income under section 104(a). Denying her claim, the IRS held that the compensation stemmed from her relinquishing property rights against Phillips and was taxable as income under 61(a). A U.S. district court granted summary judgment to the United States, holding Holland was properly denied an income tax refund for the compensation. The district court, applying the test in Commissioner v. Schleier, 515 U.S. 323 (1995), held that Holland failed to produce evidence of nonphysical injuries to support her argument for nuisance via emotional harm. The court found that her evidence only supported a finding of physical harm and because she retained all causes of action arising from physical harm, she failed to prove that the cause of action was based on a tort or that the money received was on account of personal injuries or sickness. The court held the compensation was gross income on her tax return. In Reisman v. Comm r, 87 AFTR2d Par , the Sixth Circuit The Sixth Circuit, in an unpublished per curiam order, affirmed a Tax Court decision that money received by a couple in settlement of a suit against a former employer was not compensation for damages for personal injury and was includable as income. Arnold Reisman received $350,000 for resigning his position and his tenure rights at a university. Reisman had filed a lawsuit alleging age discrimination and lost at trial. He entered settlement negotiations and the settlement did not allocate the lump sum among the various claims. The university normally buys out tenured positions at approximately three times an individual's annual salary, or, in this case, $300,000. The remaining $50,000 was paid to "close the deal" and settle all litigation. The university did not issue Reisman either a Form W-2 or a Form 1099 for either amount and Reisman did not report the payment on his return. The IRS issued a deficiency notice including the entire payment in Reisman's income. 4 CLE & Ski 2002

9 The Tax Court held that the lump sum received by Reisman was includable in income and not excludable from income under section 104(a)(2), because no portion of the lump sum was paid on account of tort or tort-type claims. The court noted that the settlement was to compensate Reisman for his resignation and relinquishment of tenure rights. Here, the university viewed the settlement as a buyout, paid at their normal rate with $50,000 to close the deal, and not an attempt to compensate Reisman for alleged personal injuries. Arnold Reisman, et ux. v. Commissioner, T.C. Memo (May 25, 2000). The Sixth Circuit, affirming the Tax Court, held that the couple didn't meet the burden of showing that the settlement is excludable. The court noted that to the extent the payment was in exchange for Reisman's federal ADEA action, the settlement is taxable because an ADEA claim doesn't sound in tort. Also noting that if the payment was for (1) giving up his rights as a tenured professor; (2) in exchange for Reisman's breach of contract claim; or (3) in exchange for the court claim for punitive damages, the settlement isn't excludable from income under section 104(a)(2). Noting that the Tax Court heard testimony that the university became dissatisfied with Reisman's employment and the university made several attempts to buy Reisman out, the court affirmed the Tax Court judgment. [2] Offset for Prior Year Medical Deductions 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. 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. 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). 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 CLE & Ski

10 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 A.F.T.R.2d (P-H) 83- th 5580 (9 Cir. Cal. 1983). [3] Emotional Distress Recoveries 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. 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 does not apply. As amended, however, 104 does permit an exclusion for damages not in excess of the amount paid for medical care attributable to emotional distress. 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. Punitive damages, however, are not excludable even when they arise out of a claim based on physical injury or physical sickness. On the other hand, amounts recovered for emotional distress resulting from physical injury are excludable. 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, 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 6 CLE & Ski 2002

11 income is not the one who suffered the physical injury or physical sickness. [4] Workers Compensation and Disability [a] 104(a)(1) Exclusion 104(a)(1) excludes from income amounts received under: workmen's compensation acts as compensation for personal injuries or sickness; or 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. This exclusion applies not only to the worker, but to amounts received by the survivor or survivors of a deceased employee. [i] No Exclusion if Payment Dependent on Age, Length of Service or Prior Contributions 1) LTR In LTR , the Service ruled that disability benefits paid to a police officer not determined by age, length of service, or prior contributions are excludable under 104(a)(1). In addition, survivor benefits not determined by the employee's prior contributions are also excludable from the survivor's income. [b] Not Retirement or Compensation for Non-Occupational Injury The 104(a)(1) exclusion does not apply to: 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 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 Distinguish retirement benefits from permanent disability benefits. The latter are excludable; the former are not. [i] Disability Benefits CLE & Ski

12 1) LTR In LTR , the Service ruled that monthly disability benefits paid to firefighters under a statute were excludable under 104(a)(1) to the extent they didn't exceed 50 percent (if they are unable to perform their customary duties) and 75 percent (if they are completely disabled) of the member's average monthly salary, and amounts paid in excess of the minimum benefits are not excludable. The Service also ruled that the benefits provided to firefighters who incur off-duty disabilities were not excludable under 104(a)(1). The Service determined that the benefits for firefighters in the course of employment were not based on age, length of service, or prior contributions, and, thus, were excludable. The benefits provided for injuries to members who incur off-duty disabilities, concluded the Service, are not in the nature of compensation acts and the benefits are not excludable. The Service concluded that benefits paid to the surviving spouse and children, regardless of the employee's length of service, are excludable from the surviving spouse's and children's income in the same proportions the deceased member would have been allowed to exclude the benefits. The Service also concluded that to the extent that benefits received under the statute aren't subject to income tax under 104(a)(1), they aren't subject to withholding tax under ) LTR In LTR the Service ruled that disability benefits paid to a worker before the conversion from duty disability retirement to regular service retirement are excludable from gross income under section 104(a)(1). Under a statute, a benefits plan member with 25 years of service may retire on "duty disability" if he or she suffers an on-the-job injury or disease as determined by a board of trustees. The statute provides that members would receive a disability pension of 50 percent of their average compensation at the time of disability retirement. Members who had not accrued 25 years of service or reached age 60 would receive supplemental disability payments. The Service noted that section 104 excludes from gross income amounts a worker receives under a worker's compensation act or under a statute that provides compensation to an employee for on-the-job personal injuries or illness. The statute was similar to a worker's compensation act. Thus, the disability benefits paid under the statute before the time of conversion from duty disability retirement to regular service retirement were excludable from gross income. 3) LTR CLE & Ski 2002

13 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. 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 two-thirds 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. 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 contributions, however, were includable in gross income. th 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. 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. 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. [ii] Payments Must be in The Course of Employment In order to be excluded, the payment has to be due to an injury or illness that is workrelated. In LTR , the Service ruled that death benefits received after plan amendment by a fireman's wife whose husband died in the line of duty were excludable from gross income. After the husband died in the line of duty fighting a fire, his spouse began receiving survivor benefits, which were includable in her gross CLE & Ski

14 income. The terms of the plan under which she was paid was determined not to be a statute in the nature of a workmen's compensation act because it authorized the payment of a benefit for all deaths, not just those occurring in the course of employment. Subsequently, the plan was amended and the wife began to receive her benefits from the provision of the plan that paid benefits only to members who died or became disabled by injuries in the line of duty. [c] Military Disability Retirement Pay - 104(a)(4) 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 The exclusion only applies if one of four qualifications are met: 3) on or before September 24, 1975, the recipient was entitled to receive such payments; 4) 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, 5) the recipient receives such a payment by reason of a combat-related injury, or 6) on application therefor, the recipient would be entitled to receive disability compensation from the Veterans' Administration. [d] Accident and Health Insurance Amounts received through accident or health insurance for personal injuries or sickness are excludable under 104(a)(3). 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. The same rule applies to amounts paid directly by the employer. A disability plan that is funded by an employer or by insurance paid for by the employer results in taxable benefits. Reg (d). 10 CLE & Ski 2002

15 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). [e] Old Case Law 1) 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). 2) Examples of such cases include: a) Libel and slander b) Alienation of affections c) Violations of constitutional rights 3) Wrongful death recoveries may or may not be excludable. a) In general, the IRS has treated amounts paid under a wrongful death statute as non-taxable. b) 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. 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. c) 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). d) As amended in 1996, 104 now provides that if the statute CLE & Ski

16 [5] Punitive Damages TAX LAW FOR THE LITIGATOR UPDATE treats all wrongful death recoveries as punitive damages, the recovery shall nonetheless be excludable. (1) Remember, in general, because of the 1996 amendments, punitive damages are always taxable. (2) This exception to the rule taxing punitive damages is grandfathered in. The wrongful death statute has to have been in effect on September 13, (3) 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. (4) 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. 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. 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. 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. 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 12 CLE & Ski 2002

17 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. 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. 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 pain and suffering damages alleged in a personal injury suit. 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 CLE & Ski

18 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. Settlement agreements have been reached in which payments over extended time periods were considered not to have an interest element. On the other hand, post-judgment interest will not be excludable from income. Though it has not been completely settled, the IRS is likely to argue that prejudgment 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 pre-judgment interest. [1] Wage Claims 3. Employment Related Claims 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. [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 USTC th 9544, 60 AFTR2d (6 Cir. 1987). 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 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 14 CLE & Ski 2002

19 if they contain elements of emotional distress and other non-physical recovery. 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. 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. 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 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). 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 Damages for intentional discrimination under Title VII of the Civil Rights Act of 1964 are taxable. Rev. Rul , C.B. 6. 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 CLE & Ski

20 amendment by the Civil Rights Act of The Supreme Court seemed to imply that recoveries under Title VII after 1991 would be excludable. 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. 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 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. 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. 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? 16 CLE & Ski 2002

21 [4] Age Discrimination As with employment discrimination, recoveries for age discrimination are taxable income. 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. 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 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 recoveries based on claims of racial discrimination brought under Title VII. 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 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. The important issue will likely be the allocation of any recovery to non-wage claims rather than wage claims, so that the amount recovered will not be subject to employment taxes and withholding. [7] Punitive Damages All punitive damage recoveries are taxable. 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. CLE & Ski

22 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. [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. 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 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. 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. 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. 18 CLE & Ski 2002

23 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. 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. [1] Lost Profits vs. Goodwill 4. Recoveries by Businesses 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. 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 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. CLE & Ski

24 When the recovery exceeds basis, the excess will be taxable, though as a capital transaction. [3] Tax Benefit Rule 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). 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 Patent infringement recoveries generally will result in ordinary income. [5] Liquidated Damages 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. The seller in such situations retains the underlying asset, so the receipt of liquidated damages is ordinary. [6] Involuntary Conversions 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. 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). The property has to be converted into property similar or related in service or use to the property so converted. 1033(a)(1). 20 CLE & Ski 2002

25 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 The recovery for breach of a covenant not to compete has been treated as 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). 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. 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. [1] What They Are 5. Structured Settlements Structured settlements are a means of settling law suits with periodic payments rather than a lump sum payment. 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. 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. The plaintiff must not either have constructive receipt of the recovery or have receipt under the economic benefit doctrine. CLE & Ski

26 [2] History 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 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). These three Revenue Rulings were subsequently codified by the Periodic Payment Settlement Act of 1982, which amended the Internal Revenue Code. [iv] 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 th under the economic benefit doctrine. See H. Rep. No , 97 Cong., 2d th Sess. 4 (1982); S. Rep. No , 97 Cong. 2d Sess. 4 (1982). [v] 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. 22 CLE & Ski 2002