PORTFOLIO

Tax Aspects of Settlements and Judgments (Portfolio 522)

Tax Management Portfolio No. 522-3rd, Tax Aspects of Settlements and Judgments, examines the tax consequences to both payor and payee pursuant to a settlement or judgment. It analyzes the tax issues that arise in personal injury lawsuits as well as non-personal injury lawsuits. In the personal injury context, prior law and the rules in effect after the amendment of §104(a)(2) by the Small Business Job Protection Act of 1996 are discussed in detail.

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Tax Management Portfolio No. 522-3rd, Tax Aspects of Settlements and Judgments, examines the tax consequences to both payor and payee pursuant to a settlement or judgment. It analyzes the tax issues that arise in personal injury lawsuits as well as non-personal injury lawsuits. In the personal injury context, prior law and the rules in effect after the amendment of §104(a)(2) by the Small Business Job Protection Act of 1996 are discussed in detail.
Payments pursuant to a settlement or judgment give rise to tax consequences to both payor and payee. This portfolio examines the includibility of payments pursuant to settlements and judgments, as well as the deductibility and reporting of those payments. Specifically, this portfolio examines planning techniques which may be undertaken to enhance the tax results for both plaintiffs and defendants, as well as those who are only considering litigation. A wide array of substantive litigation is considered in this portfolio, including the tax aspects of personal physical injury cases, various types of employment-related claims, business recoveries and liabilities, structured settlements, marital dissolutions, and antitrust payments and recoveries. The tax treatment of legal fees is also examined.
Special emphasis is placed on issues relating to the allocation of a lump sum awarded in a judgment or a settlement between several claims made by a plaintiff. In addition, special rules governing structured settlements are analyzed in detail. The tax treatment of attorneys’ fees is discussed in detail, including the enactment of the American Jobs Creation Act of 2004 and the Supreme Court decision in Comr. v. Banks and Comr. v. Banaitis, both of which attempt to resolve the acidic split in the Circuit Courts of Appeals which existed with respect to this issue.


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AUTHORS

ROBERT W. WOOD
Robert W. Wood is a 1979 graduate of University of Chicago Law School where he earned a Juris Doctor, won the Florence James Adams Prize and received a University of Chicago Scholarship. He practices law with Wood & Porter, A Professional Corporation, a law firm in San Francisco, California (www.woodporter.com) where he provides services for clients on a variety of state, federal, and international tax matters. Mr. Wood is admitted to practice law in California, New York, Arizona, Washington, Montana, Wyoming, and the District of Columbia. He is also admitted to practice as a Solicitor in England and Wales. Mr. Wood has been designated by the State Bar of California as a Certified Specialist in Taxation. The author of 31 books in the field of taxation, Mr. Wood is a leading authority and practitioner, particularly on the taxation of damage awards and settlement payments, and frequently advises clients on this unique area of the tax law. He is the author of Taxation of Damage Awards and Settlement Payments (3d Ed. 2005 © Tax Institute, available at www.damageawards.org). Mr. Wood is also the founder and Editor-in-Chief of The M&A Tax Report, a national monthly newsletter addressing tax techniques and trends affecting mergers and acquisitions. For a complete list of Mr. Wood's publications, please visit www.rwwpc.com.

TABLE OF CONTENTS

Detailed Analysis

I. Introduction

A. In General

B. Overview

C. Settlements vs. Judgments

II. Origin of Claim Test

III. Amounts Received on Account of Personal Injuries Or Sickness

Introductory Material

A. Amounts Received Under Workmen's Compensation Acts

1. Qualified Law Requirement

2. Occupational Injuries Requirement

3. Payments Must Not Be Based on Age, Length of Service or Prior Contributions

B. Amounts Received Through Accident or Health Insurance for Personal Injuries or Sickness

C. Pensions, Annuities, or Disability Payments Received for Personal Injuries

D. Disability Payments for Injuries Suffered in Terrorist Attacks

E. Damages Received for Personal Injuries or Sickness

1. Background

a. Scope of “Physical Injury”

b. Meaning of “Personal Physical Injuries or Physical Sickness”

2. The Supreme Court Decisions

a. U.S. v. Burke

b. Comr. v. Schleier

c. The Aftermath of Burke and Schleier

3. Personal Injuries

a. Personal Injury Claims

b. Emotional Distress

c. Wrongful Death

d. Injury to Reputation

e. Loss of Consortium and Alienation of Affections

f. False Imprisonment

4. Employment Related Recoveries in General

a. Severance Pay

b. Back Pay Awards

c. Employment Tax Consequences

(1) Recoveries Subject to Self-Employment Tax

(2) Allocations for Employment Tax Reasons

(3) Defendant Employer Ultimately Liable for FICA

(4) Penalties for Failure to Withhold

d. Discrimination Based on Race, Age, or Sex

(1) Sex Discrimination

(2) Age Discrimination

(3) Racial Discrimination

e. Recoveries for Wrongful Termination

f. Other Employment Recoveries

(1) Sexual Harassment Recoveries

(2) ADA Recoveries

g. ERISA Claims

(1) Wages Characterization

(2) Allocation of Nontaxable Benefits

h. Checklist for Settling Employment Cases

(1) Allocation vs. No Allocation

(2) Weight Given to Allocations

(3) Absence of Adverse Interests

(4) Maintaining Consistency in Tax Reporting

(5) Scope of Settlement Discussions

(6) General Releases and Lump Sum Payments

(7) Employer Reporting Obligations

(8) Insurance Considerations

5. Periodic Payments

6. Punitive Damages

a. What Constitutes Punitive Damages

b. Punitive Damages Allocations

c. Taxation of the State's Portion of Punitive Damages

d. The “Best Evidence” Rule

e. Punitive Damages Without a Judgment

f. Assignment of Punitive Damage to Avoid Taxation

7. Interest

a. Prejudgment Interest

b. Interest in Cases Settling on Appeal

c. Significance of Payor's Intent

d. Postjudgment Interest and Timing Issues

e. Beware of Interest Designation

f. Delay Damages

IV. Non-Personal Injury Cases

Introductory Material

A. Ordinary Income or Capital Gain

B. Punitive Damages

C. Antitrust Recoveries

1. Taxation of Punitive Damages

2. Taxation of Compensatory Damages

3. Reduction of includible Antitrust Recoveries by a Special Deduction

a. Compensable Injury

(1) Patent Infringement

(2) Breach of Contract or Fiduciary Duty or Relationship

(3) Antitrust Law Violations

b. Compensatory Amount

(1) Interest on Compensatory Amount

(2) Settlement of Civil Action for Damages

c. Amounts Paid or Incurred in Securing the Award or Settlement

d. Unrecovered Losses

(1) Injury Period

(2) Net Operating Losses Attributable to Compensable Injuries

(3) Application of Losses Attributable to a Compensable Injury

e. Effect on Net Operating Loss Carryovers

V. Payor's Deduction of Payments

A. Difference Between Settlements and Judgments

B. Business Expenses

1. General Rule of Deductibility

a. Punitive Damages

b. Timing Issues

2. Business Expense Requirements in General

3. Ordinary and Necessary Expenses

4. Reasonableness of Expenses

5. Trade or Business Nexus

a. Directly Connected

b. Required Nexus

6. Nexus to Income-Producing Activity

7. Issues Surrounding Personal Expenditures

a. Payor's Identity

b. Prior Public Policy Restrictions

8. Deductibility of Payments Made by Corporate Affiliates and Other Corporations

9. Disallowance of § 212 Expenses for AMT Purposes

C. No Deductions for Fines or Penalties

1. Fines vs. Late Fees

2. Fines vs. Compensatory Payments

3. Restitution Payments

4. Penalties Which Encourage Compliance with the Law

5. Attorneys’ Fees in Defending Against Fines

D. Deduction of Civil and Criminal RICO Payments

1. RICO Payment Deductions

2. Deduction of Legal Fees in RICO Act Cases

E. Timing of Deductions

1. General Rule of Deductibility

2. Accrual Basis Taxpayers

3. Applicability of Economic Performance Rules

F. Deduction Under § 165 vs. § 162

G. 2004 AJCA Above-the-Line Attorneys’ Fee Deduction

1. False Claims Act

2. Scope of the “Catchall”

3. Excluded Employment Cases

4. Punitive Damages

5. Effective Date

H. Banks and Banaitis Attorneys’ Fees Deduction

1. Background

2. The Holding

3. Exceptions

a. Fee Shifting Statutes

b. Injunctive Relief

I. Deductibility vs. Capitalization of Legal Fees

1. Sale vs Preservation

2. Acquisitions and Other Costs

3. Acquiring or Defending Goodwill

4. Litigation Over Purchase

5. Property Title Litigation

6. Securities Violations Payments

7. Treatment of Environmental Liabilities

8. Property Value Increase

9. Shareholder Litigation

J. Reporting Payments to Attorneys

1. Section 6045(f)

2. The Middleman Regulations

VI. Structured Settlements

A. General

B. Personal Injury Liability Assignments: § 130

1. Qualified Assignment

2. Qualified Funding Asset

C. Timing of Payor's Deduction

1. Accrual-Basis Taxpayer

a. In General - The Economic Performance Requirement

b. Contested Liabilities

2. Economic Performance in the Case of Qualified Assignments

3. Payments to Designated Settlement Funds and Qualified Settlement Funds

a. Designated Settlement Funds

(1) Definition of a Designated Settlement Fund

(2) Qualified Payments

(3) Election

b. Qualified Settlement Funds

c. Taxation of Designated Settlement Funds and Qualified Settlement Funds

d. Tax Compliance

e. Taxation of Transferors to Designated Settlement Funds or Qualified Settlement Funds

(1) In General

(2) Economic Performance Requirement with Regard to Transfers by Accrual-Method Transferors

(3) Transfers of Insurance Amounts

(4) Statement To the QSF or DSF

(5) Distributions To Transferors

f. Taxability of Distributions to Claimants of Designated Settlement Funds or Qualified Settlement Funds

D. Non-Qualified Assignments

1. Emerging Use of Non-Qualified Assignments

2. Lack of Constructive Receipt

3. Lack of Economic Benefit

4. Lack of Cash Equivalency

5. Lack of Guidance

E. Treatment of Attorneys’ Fees

1. Periodic Payment of Attorneys’ Fees

2. Need to Address Fees Early

3. Annuity Payments to Attorneys

4. Assignment of Income and Assignments of Attorneys’ Fees

5. Opt-Out Class Action Lawsuits

F. Advantages and Disadvantages of Structured Settlements

1. Payment Stream vs. Lump Sum

2. Insolvency Risk

3. Considerations for Defendant

4. Interest Rate Determination

5. Viatical Settlements and Discount Transactions

6. Excise Tax on Structured Settlement Factoring Transactions

VII. Substantiating Tax Treatment

A. Introduction

B. Written Evidence

1. Complaint Refers to the Claim

2. Other Evidence Aside From the Complaint

a. Allocating Between Claims

b. Identity of Payor

3. Allocating and Documenting Claims

a. Reasonable Relationship

b. Pro Rata Allocations

c. Adverse Interests Lacking

d. Importance of Settlement Agreement

e. Explicit Manifestations of Intent

4. Use of General Releases Without Tax Allocations

a. Taxpayer's Burden of Proof

b. Are Taxes Essential to Settlement?

c. Intent of Payments

5. Business Recovery Allocations

a. Lost Profits Presumption

b. Demonstrating Harm to Capital and Establishing Basis

c. Difficulties in Avoiding Ordinary Income Characterization

6. Establishing Basis

7. Timing of Tax Characterization Agreement

8. Allocation in Judgment

9. Using Jury Instructions

C. Intent of Payor

D. Determining Tax Treatment

1. Maintaining Consistency in Tax Reporting

2. Value of Testimony

3. Value of Consistency in Reporting and Tax Indemnity Provisions in Settlements


WORKING PAPERS

Working Papers

Table of Worksheets

Worksheet 1 Sample Declaration of Trust for The Claimants Settlement Fund

Worksheet 2 Sample Settlement Agreement Between Defendant Employer and Union for Unlawful Plant Closure

Worksheet 3 Sample Release Between Individual and Defendant Employer for Unlawful Plant Closure

Worksheet 4 Sample Partial Assignment of Claim Agreement

Worksheet 5 Sample General Employment Release and Settlement Agreement (California Law)

Bibliography

OFFICIAL

Statutes:

Legislative History:

Treasury Rulings:

Cases:

UNOFFICIAL

Periodicals:

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