Kenneth P. Brier and Michael D. Brier,
BridgeTower Media Newswires
In virtually every transaction an American undertakes, he or she has a silent partner, namely the Internal Revenue Service, and often a state revenue department too. That “partner” can often end up claiming up to half the deal.
And, though it’s easy to forget this, the deals in which the IRS cuts itself in commonly include recoveries from the settlements of disputes, whether or not incorporated in a court judgment, as well as judgments or arbitration awards not reflecting any voluntary settlement between the parties.
The converse is also true. The IRS may share the burden of litigation losses, as well as the costs of litigation, by way of characterization of such losses and costs as deductible or (at least) as capitalizable.
Business lawyers are necessarily used to evaluating all angles of a deal, including the tax angles. And in business matters posing any tax complications, they do not seem to hesitate to bring in their tax partner, or if necessary, an outside tax specialist to review the tax aspects of the deal.
In the fast-paced and contentious world of civil litigation, however, where settlements are often reached on the courthouse steps, tax implications may be an afterthought, if they factor into the mix at all. Yet the tax implications can be every bit as important to litigants as they are to parties to a business deal.
Different tax strokes for different folks
Though it is not desirable for the tax consequences to be a tail wagging the dog, it still remains the case that similar substantive results can be couched in different ways that might have significantly different tax results.
Depending on the facts, a plaintiff’s recovery might be treated as (1) included or excluded from gross income, (2) if included, characterized as ordinary income or capital gain, or (3) if excluded, possibly characterized as a return of capital (with no current tax effects but affecting basis and thus future taxes).
For the defendant, the payment might be (1) deductible as a business-type expense, (2) deductible in determining adjusted gross income, (3) deductible as an itemized deduction as related to the production of income, income-producing property or tax matters, (4) capitalizable, offering a future tax benefit only, or (5) neither deductible nor capitalizable.
More specifically, compensation for injuries or sickness may be excluded from a claimant’s gross income, but only if the damages fit a specified list of items set forth in IRC §104 (including compensation for physical injuries or sickness).
In employment actions, a common issue is whether the recovery is to be characterized as wages or as something else. If characterized as wages, the damages commonly generate payroll tax liabilities, as well as income tax consequences. And either litigant’s legal fees (including a contingent fee award) may be deductible either “above the line,” or as an itemized deduction, or not deductible at all, depending on the circumstances.
As a case in point, under IRC §62(a)(20), (a)(21) and (e), legal fees related to a lengthy list of discrimination and tax whistleblower claims may be deducted “above the line” as long as they meet the more general tests of deductibility.
Structured settlements are subject to their own special rules.
Needless to say, a civil action commonly is not “one thing,” and the original complaint commonly will allege a multiple of sins. Any ultimate recovery might relate to any or all of those allegations. But a recovery for one count in the complaint may commonly entail very different tax consequences than a recovery for another count. These differences require an allocation of the recovery among the causes of action.
Voluntary settlements and judgments (whether in court or in binding arbitration) are treated the same for tax purposes, but a voluntary settlement is almost always a superior vehicle for refining the tax aspects of the resolution of the litigation.
A settlement provides a much enhanced opportunity to structure the details of the resolution to the satisfaction of the parties. It offers much greater flexibility than a judgment determined solely by a court.
It makes sense for the parties to set forth the allocation in their settlement documents and then to adopt consistent tax treatments. Though such treatment can go far in supporting the desired tax characterizations, the IRS is not bound by any of this. The IRS may evaluate the allocation in accordance with a “reasonable relationship” test, based on the pleadings and the parties’ course of conduct in the litigation.
In the absence of documentation and in the absence of consistent treatment, the IRS understandably will have a greater incentive and better odds in reevaluating a party’s allocation.
In some cases the parties will hold adverse positions on the tax characterization of their settlement, but in other cases there is no adversity. Not surprisingly, the IRS will scrutinize the latter cases with greater attention.
Dealing with tax aspects at different stages of litigation
It makes sense for litigators to familiarize themselves with applicable tax law, just as they must often familiarize themselves with other substantive areas of law. But a litigator also should consider enlisting the help of a tax lawyer, whether from inside or outside the firm, in settling a case, if time permits and if the dollars are large or the tax terrain uncertain.
A tax lawyer’s assistance can help litigators fulfill their duties to the client to explain and to address the tax consequences, as well as to avoid subsequent tax controversy.
Getting the tax aspects wrong might even risk a malpractice claim. See Jalali v. Root, 109 Cal. App. 4th 1768 (2003), where a lawyer, successful in obtaining a $2.75 million settlement for the plaintiff, nonetheless required an appeal to avoid a $310,000 malpractice award based on faulty tax advice that income taxes would be payable only on the net proceeds after his contingent fee.
In fact, ideally a tax lawyer would be brought in even as early as the preparation of a demand letter, since the tax consequences of the litigation ultimately will relate back to the “origin of the claim.” The IRS and the courts have consistently held the complaint to be the single most important document for determining the tax consequences of a resolution of the case.
Even if a case has already been reduced to a judgment, one should not give up on the idea of molding its tax consequences appropriately. A surprising number of cases subject to post-judgment motions or to appeal can still be resolved by settlement, opening up the possibility of finessing their tax aspects.
Some cases in point
Some of the foregoing principles are illustrated in Massmanian v. Dubose, Civil Action No. 07-2511-BLS1, a Superior Court case decided by now-Supreme Judicial Court Chief Justice Ralph D. Gants.
The plaintiff in Massmanian had been a minority stockholder in a closely held S corporation. He had a falling out with the majority stockholder and was fired from his job with the company.
The parties’ settlement agreement provided for total payments of $1.9 million, including $400,000 in consideration of release of a wrongful discharge claim (i.e., severance pay), $800,000 for payment of the plaintiff’s stock (including interest), and $700,000 to pay the contingent fee award of the plaintiff’s law firm. The $800,000 stock redemption was pegged to a retroactive date, and the parties stipulated that the $700,000 fee reimbursement was to be treated as non-income “to the extent permitted by law.”
Both the retroactive stock redemption and the “non-income” fee reimbursement ended up being the subject of a new round of litigation. The parties, as between themselves, could choose a retroactive date for the $800,000 redemption, so the court declined to find a breach of the settlement agreement by the defendants’ failing to issue the plaintiff a K-1 reflecting the non-retroactive date. However, it noted that the IRS likely would not accept such backdating, so the defendants acted “at their peril.”
The parties also disputed the tax treatment of the $700,000 fee reimbursement. Despite the parties’ agreement to treat the reimbursement as non-income, the court refused, largely on public policy grounds, to bar the issuance of a Form 1099 reporting income to the plaintiff. Though reluctant to decide U.S. tax issues, it noted that inclusion in gross income was a near certainty under Commissioner v. Banks, 543 U.S. 426 (2005).
By our calculations, the swing of the plaintiff’s $700,000 reimbursed legal fee between excludible from income and includible (but not deductible) would result in an increase in his federal and Massachusetts income taxes to the tune of $270,000 — an amount not factored into the original settlement.
Two recent Tax Court cases, involving brothers Edward and Sumner Redstone, members of a famously litigious family, provide an interesting, and contrasting, case study of gift taxes incurred and avoided. Those cases, heard by the same judge, are Estate of Redstone v. Commissioner, 145 T.C. No. 11 (2015), and Redstone v. Commissioner, 110 TCM 564 (2015).
A 1972 settlement of family litigation entailed transfers of stock of the family business, National Amusements, Inc., by each brother to family trusts. Neither of the brothers reported his transfer as a gift, and neither filed a gift tax return for it. Years later, the IRS got wind of them.
The Tax Court ultimately treated Sumner’s transfer as taxable gift, but not Edward’s. The court treated Edward’s transfers of one-third of his NAI shares as made in the ordinary course of business, with receipt of full and adequate consideration, namely (1) recognition by the family patriarch, Mickey, and by Sumner that Edward, rather than a putative oral trust, was the real owner of the remaining two-thirds of the NAI shares registered in his name, and (2) NAI’s agreement to pay Edward $5 million in exchange for those shares.
By contrast, the court found that Sumner was not required to make any transfers under the settlement agreement that resolved Edward’s lawsuits, as he was required only to execute certain releases, and it remained unpersuaded that Sumner made his transfers to facilitate the settlement of the litigation.
Moral of the tales
The cases described above, like countless others, would have benefited from a serious review of their tax aspects before the final inking of the settlement agreements.
In fact, taxes should have been considered even before that. A plaintiff’s tax position is helped by adopting a consistent posture from the time of sending a demand letter and filing a complaint; and both parties can help themselves by adopting a mutually consistent posture, to the extent they are able, in any settlement agreement, court judgment or arbitration award.
At the very least, the characterization of the settlement for tax purposes should be made clear on its face, and the parties should understand the consequences.
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Kenneth P. Brier is a partner at Brier & Ganz in Needham, with a practice focusing on tax and estate planning and wealth preservation matters. He provided a pre-litigation consultation for the plaintiff in the above-mentioned Massmanian v. Dubose case on the tax aspects of his settlement. Michael D. Brier is an associate at Arrowood Peters in Boston, with a litigation practice encompassing business disputes, employment litigation and professional malpractice.
