Wednesday, July 17, 2019
Many legal cases are settled out-of-court. Cases could involve divorce, wrongful death, securities fraud, false advertising, civil rights, sexual harassment, product liability, reverse discriminations, or damages for a spilled cup of hot coffee just to name a few. But, if a recovery from a lawsuit or out-of-court settlement is obtained, the tax consequences must be considered. A recent case involving damages that a dairy sustained as a result of stray voltage illustrates this point.
The tax treatment of settlements and court judgments, that’s today’s topic.
Recoveries from out-of-court settlements or as a result of judgments obtained may fall into any one of several categories. Quite clearly, damages received on account of personal physical injury or physical sickness are excluded from income. I.R.C. §104(a)(2). Thus, amounts received on account of sickness or mental distress may be received tax-free if the sickness or distress is directly related to personal injury. For instance, settlement proceeds from a wrongful termination suit that are allocable to mental distress are excludible from income where the mental distress is caused directly by the wrongful termination. See, e.g., Barnes v. Comr., T.C. Memo. 1997-25. Those amounts that are allocated to punitive damages are not excludible. Id.
As the regulations point out, nontaxable damages include “an amount received (other than workmen's compensation) through prosecution of a legal suit or action based on tort or tort-type rights, or through a settlement agreement entered into in lieu of such prosecution.” Treas. Reg. § 1.104-1 (1970). The IRS has determined, for example, that excludible damages include damages for wrongful death (Priv. Ltr. Rul. 9017011 (Jan. 24, 1990)); payments to Vietnam veterans for injuries from Agent Orange (Priv. Ltr. Rul. 9032036 (May 16, 1990)); and damages from gunshot wounds received during a robbery (Priv. Ltr. Rul. 8942083 (Jul. 27, 1989)).
Categorization of a settlement or award is also highly dependent on how the wording of the legal complaint, settlement and release are drafted. Wording matters. This point was evident in a recent Tax Court case. In Stepp v. Comr., T.C. Memo. 2017-191, the petitioners, a married couple, could not exclude payments received in settlement of the wife’s Equal Employment Opportunity Commission complaint in which she alleged disability and gender-based discrimination, retaliatory harassment for a job reassignment. The Tax Court noted that each of the complaint, settlement and release provided for emotional and financial harms. There wasn’t mention of any physical injury or sickness. Perhaps those documents were drafted without much thought given to the tax consequences of any eventual award or settlement.
1996 Legislation and the Aftermath
1996 legislation specified that recoveries representing punitive damages are taxable as ordinary income regardless of whether they are received on account of personal injury or sickness. Small Business Job Protection Act of 1996, P.L. 104-188, Sec. 1605(a). See, e.g., O'Gilvie v. United States, 519 U.S. 79 (1996); Whitley v. Comr., T.C. Memo. 1999-124. But punitive damages that are awarded in a wrongful death action are not taxable if applicable state law in effect on September 13, 1995, provides (by judicial decision or state statute) that only punitive damages may be awarded. In that case, the award is excludible to the extent it was received on account of personal injury or sickness. Small Business Job Protection Act, P.L. 104-188, § 1605(d)). The enactment also made it clear that damages not attributable to physical injury or physical sickness are includible in gross income.
In 2006, the U.S. Circuit Court of Appeals for the District of Columbia ruled that the distinction drawn in the 1996 amendment was unconstitutional. Murphy v. United States, 460 F.3d 79 (D.C. Cir. 2006). In the case, the plaintiff sued her former employer and was awarded $70,000 ($45,000 for mental pain and anguish and $25,000 for “injury to professional reputation”). The plaintiff originally reported the entire $70,000 as taxable and then filed amended returns excluding the income. The IRS maintained that the entire $70,000 was taxable, and the trial court agreed. On appeal, the court held that the $70,000 was not excludible from income under the statute, but that I.R.C. §104(a)(2) was unconstitutional under the Sixteenth Amendment since the entire award was unrelated to lost wages or earnings, but were, instead, payments for the restoration of the taxpayer’s human capital. Thus, the entire $70,000 was excludible from income. However, in late 2006, the court vacated its opinion and set the case for rehearing. Upon rehearing, the court reversed itself and held that even if the taxpayer’s award was not “income” within the meaning of the Sixteenth Amendment, it is within the reach of the power of the Congress to tax under Article I, Section 8 of the Constitution. In addition, the court reasoned that the taxpayer’s award was similar to an involuntary conversion of assets – the taxpayer was forced to surrender some part of her mental health and reputation in return for monetary damages.” Murphy v. Internal Revenue Service, 493 F.3d 170 (D.C. Cir. 2007), reh’g. den., 2007 U.S. App. LEXIS 22173 (D.C. Cir. Sept. 14, 2007), cert. den., 553 U.S. 1004 (2008).
What About Lost Profit?
In many lawsuits, there is almost always some lost profit involved, and recovery for lost profit is ordinary income. See, e.g., Simko v. Comm’r, T.C. Memo. 1997-9. For recoveries in connection with a business, if the taxpayer can prove that the damages received were for injury to capital, no income results except to the extent the damages exceed the income tax basis of the capital asset involved. The recovery is, in general, a taxable event except to the extent the amount recovered represents a return of basis. Recoveries representing a reimbursement for lost profit are taxable as ordinary income.
What if Contingent Fees are Part of an Award?
If the amount of an award or court settlement includes contingent attorney fees, the portion of the award representing contingent attorney fees is includible in the taxpayer’s gross income. Comr. v. Banks, 543 U.S. 426 (2005), rev’g and rem’g sub. nom., Banks v. Comr., 345 F.3d 373 (6th Cir. 2003). For fees and costs paid after October 22, 2004, with respect to a judgment or settlement occurring after that date, legislation enacted in 2004 provides for a deduction of attorney’s fees and other costs associated with discrimination in employment or enforcement of civil rights. I.R.C. § 62(a)(19).
Interest on Judgments
Statutory interest imposed on tort judgments, however, must be included in gross income under I.R.C. § 61(a)(4), even if the underlying damages are excludible. See, e.g., Brabson v. United States, 73 F.3d 1040 (10th Cir. 1996).
Under I.R.C. § 104(a), amounts received under workmen’s compensation as compensation for personal injuries or sickness are excludible. However, the exclusion is unavailable to the extent the payment is determined by reference to the employee’s age or length of service.
Impact of the Tax Cuts and Jobs Act (TCJA)
Under the TCJA, some settlement recoveries will cause the full amount of the award (the gross recovery) to be subjected to taxation. Due to the TCJA’s limitation on itemized deductions, the award is included in income without an offset for attorney fees. However, the TCJA does not impact awards that are on account of qualified personal physical injury. Those awards are tax-free as noted above. Also not impacted are employer-related claims – attorney fees for these type of cases remain an “above-the-line” deduction. The TCJA does, however, modify the tax rules involving sexual harassment cases.
Facts. The issue of the proper tax treatment of a jury award and interest was at issue recently in a case involving a Wisconsin dairy operation what suffered affected by stray voltage. In Allen v. United States, 331 F. Supp. 3d 852 (E.D. Wisc. 2018), the plaintiff received a jury award of damages, plus interest, as a result of his lawsuit against a utility company. Stray voltage had harmed his cattle and dairy operation causing decreased milk production, damage to his property and dairy herd, lost profits and increased veterinary bills from 1976 to 2000. The plaintiff’s expert testified that the inflation-adjusted economic losses to the dairy and cattle operation were almost $14 million. The jury returned a verdict for the plaintiff in the amount of $1,750,000 with $750,000 to economic damages and $1,000,000 to tort damages. In 2005, after the jury’s award was affirmed on appeal, the plaintiff received the funds along with $519,233,35 in accrued interest. The plaintiff also paid attorney fees, costs and expenses of $1,230,384.38.
On the plaintiff’s 2005 return, the plaintiff reported the $750,000 of economic damages as ordinary income on Schedule F and the $519,233.35 of interest as capital gain on Schedule B. $548,736 of legal expenses were reported on Schedule F as farm business expense. The $1,000,000 of tort damages was not reported, nor was Form 8275 filed explaining why the tort damages were not reported on the return. The 2005 return showed a tax liability of $124,827 which the plaintiff paid. The IRS audited and treated the $750,000 of economic damages, $1,000,000 of tort damages and $519,233.28 of interest as ordinary income on Schedule F. The IRS also assessed an accuracy-related penalty for the $1 million of underreported income. The IRS assessed an additional $145,836.89 in tax, interest and penalties. The plaintiff then filed an amended 2005 return with the IRS seeking a refund of $130,215. On the amended return, the plaintiff claimed $119,408 of legal expenses as an itemized deduction on Schedule A, categorized the $519,233.25 of interest as capital gain income on Schedule B, and claimed the $1,000,000 tort damage award as a nontaxable recovery of capital on Schedule B, Form 4797. The plaintiff also did not include the $750,000 of economic damages, but later agreed that it constituted ordinary income as reported on the original 2005 return. The plaintiff then sued in federal district court for a refund.
Interest. The court determined that the interest award was properly includible in the plaintiff’s gross income as arising directly from the plaintiff’s damage award for loss to the cattle and dairy business. The court noted that the plaintiff had failed to rebut the determination of the IRS that the interest award was ordinary income. As such, the interest award was also subject to self-employment tax – there was a nexus between the interest on the damage award for loss to the plaintiff’s cattle and dairy business and the underlying business.
Tort damages. The court also held that the $1 million of tort damages constituted ordinary income, based on the origin of the claim and because the facts did not show that the plaintiff was asserting any recovery for interfering with (and devaluing) his real property as a capital asset. The plaintiff had exclusively presented evidence on economic damages - lost profits from milk production and the sale of both dairy and beef cattle. The court noted that the plaintiff had advised the jury to base the amount of the tort damages on economic damages. The plaintiff’s lawyers made no attempt to establish that the plaintiff was seeking recovery for interference with the plaintiff’s real property as a capital asset.
Penalty. The court also upheld the accuracy-related penalty on the basis that the plaintiff did not disclose his position with respect to the non-reporting of the tort damages and because he was advised by an accountant that his treatment of the tort damages was not correct. Thus, the plaintiff did not qualify for the reasonable cause exception to the I.R.C. §6662 penalty contained in I.R.C. §6664(c)(1).
Jury awards and cases where an award is received as a result of a settlement can result in some tricky tax consequences. As Allen illustrates, ag cases can involve a mix of damages with numerous and unique tax consequences.