Focus on Taxable Damages
IRS Publishes Audit Guide for Lawsuit Awards
The government believes that a lot of potential tax revenue from lawsuit awards is going uncollected. The Internal Revenue Service has released this year for the first time an audit guide to its field agents that contains examination techniques for lawsuit awards and settlements. There is no indication that structured settlements are being singled out for scrutiny.
The project began in Alabama when the IRS picked up on newspaper articles that reported numerous lawsuits were being resolved in that state either by verdict or settlement for substantial amounts. The IRS determined that the vast majority of these were escaping taxation, that virtually none of the payments were being reported. In the examination of 1994 and 1995 tax returns, agents found that the taxpayer had classified all or most of the settlement as “compensatory,” usually for “personal injuries,” determining that the proceeds were nontaxable. According to the audit guide, this pattern was repeated in virtually all of the lawsuit cases, regardless of whether the claims were for fraudulent actions, defamation of character, employment related disputes, product liability, negligence, wrongful death, etc., and regardless of whether claims for punitive damages were involved.
Everything Income Unless Excluded
Section 61 of the Internal Revenue Code (26 U.S.C.) states that all income from whatever source derived is taxable, unless specifically excluded by another IRC section. In certain situations, a lawsuit settlement amount might be paid to reimburse a taxpayer for losses, and no gain would have to be recognized under IRC § 1001, as a return of capital. But, section 104(a)(2) is the only provision that specifically addresses income exclusions for any type of lawsuit proceeds.
The question of “what are personal injuries” has been central to much litigation over section 104(a)(2). The issues have encompassed physical versus non-physical (mental anguish) injuries and sickness, and whether punitive damages are received on account of personal injuries. In 1989, Congress amended section 104(a)(2) referencing punitive damages and non-physical injuries. The wording of this amendment created more controversy than before. The IRS took the position that punitive damages are not received on account of personal injuries under section 104(a)(2), and therefore are not excludable from gross income.
In 1996, on the heels of several court decisions that had upheld the position of the IRS, Congress resolved the controversy by amending section 104(a)(2) again. Not only are punitive damages not excludable, regardless of whether received in connection with a physical or non-physical injury or sickness, Congress now restricted the tax exclusion to just physical injuries or physical sickness. Since the August 21, 1996, effective date of that amendment the IRS has a more definite guideline to work with than it had previously.
The new audit guide for lawsuit awards was designed specifically for training purposes under the IRS Market Segment Specialization Program (MSSP) and “under no circumstances should the contents be used or cited as authority for setting or sustaining a technical position,” the guide notes. However, there can be no doubt that the IRS intends with the help of this how-to guide to focus on lawsuit awards, looking for taxable damages.
Allocation Critical to Structures
The allocation of damages between taxable and non-taxable categories applies equally to cash settlements as well as structured settlements, which include promises of future payments. But, because the obligation to make future payments usually is assigned to a third party under special rules that make it a tax-neutral transaction, it is critical that all future payments due to the claimant be exempt under IRC § 104(a)(2).
It is well settled that a case involving both taxable and non-taxable damages can be structured in a qualified assignment as long as the taxable damages do not go toward funding the future payments. The allocation must be clear and defensible.
The original defendant, or its insurer, who commits to future payments under the terms of the settlement agreement may make a “qualified assignment” of that liability under the provisions of IRC § 130(c), if the claimant has agreed. The assignor pays consideration to the new obligor in an amount equal to the cost of an annuity or U.S. government obligation to make those payments, plus usually a nominal assignment fee. If the third-party purchases a “qualified funding asset” within 60 days, the money it receives from the defendant or liability insurer does not have to be reported to the IRS as income. The assignee does not get a deduction when the payments are made to the claimant.
Most qualified assignments contain a reversionary clause which provides that the ownership of the funding asset will be transferred to the assignee — the original defendant or its liability insurer — in the event section 130(c) has not been satisfied and the assignment of the future payment obligation will terminate. This can become very unsettling to the assignor if there is any doubt as to whether the future payments are excluded from taxable income under section 104(a)(2). Section 130(c)(2)(D) specifically states that such periodic payments from personal injury claims must be excludable from the gross income of the recipient under section 104(a)(2). This reversionary specter can be avoided if the defendant or insurer transfers money into a qualified settlement fund under Treasury Regulations § 1.468B.
Workers’ compensation payments, which are excludable from gross income under section 104(a)(1), may also be assigned under section 130(c). However, the audit of workers’ compensation claims is not covered in the new IRS guide.
The 1996 amendment also provides that personal injury recovery amounts excludable for emotional distress are limited to actual out of pocket medical costs in cases of non-physical injuries, such as discrimination, fraud, etc. However, all amounts received on account of a physical injury, with the exception of punitive damages, are excludable under section 104(a)(2), including amounts for emotional distress.
A Checklist for the Audit
Following are issues, as listed in the MSSP Audit Guide for Lawsuit Awards, for proceeds received after August 20, 1996:
· Lawsuit proceeds are unreported.
· All punitive damages are taxable whether received in relation to a physical or non-physical injury.
· Determine if any of the settlement proceeds are designated as interest, and if so, such interest is reported as income.
· Verify that amounts excluded from income were received in a case of physical injury. If it was not a physical injury, the only amounts excludable under IRC section 104(a)(2) are out of pocket costs for medical expenses incurred to treat emotional distress.
· For out of court settlements for physical injury cases, determine if proper amounts were allocated between compensatory and punitive damages.
· Verify the amount of out of pocket expense excluded for emotional distress in a non-physical injury case (that is, discrimination, fraud, etc.)
· Verify that the taxpayer reported taxable amounts as gross rather than reporting them net of legal fees paid.
· Allowable legal fees should be deducted on Schedule A as miscellaneous itemized deductions, unless the origin of the claim litigated is related to a Schedule C (independent contractor), or a capital transaction.
· The legal fees deducted on Schedule A are a tax preference item for purposes of alternative minimum tax (AMT).
· For the purposes of the AMT credit, the legal fees which created AMT are not allowed to generate the credit. They are “exclusion” items.
The audit guide notes that it does not address the proper treatment of legal fees paid and deducted in taxable years prior to the year of recovery.
Allocations Should be Examined
“The allocation issues will be particularly important in out-of-court settlements for physical injury cases,” the audit guide observes. “Because many cases are settled to avoid the imposition of punitive damages, it is anticipated that some taxpayers may erroneously allocate amounts between excludable and punitive damages in these cases,” according to the IRS. “Determining the correct allocations among taxable payments and non-taxable payments is usually the most difficult part of these examinations.”
For jury or court verdicts, if damages have been clearly allocated to an identifiable claim in an adversarial proceeding by judge or jury, the IRS usually will not challenge their character because of the impartial and objective nature of the determinations, the field auditors are being told. But, the IRS cites as possible exceptions Robinson v. Commissioner, 102 T.C. 116, 122 (1994) and Kightlinger v. Commissioner, T.C. Memo. 1998-357.
Many lawsuits settled out of court prior to a jury verdict should be closely reviewed, the IRS field agents are instructed, and facts and circumstances should be carefully determined. The allocation among the various claims of the settlement can be challenged where the facts and circumstances indicate that the allocation does not reflect the economic substance of the settlement. The audit guide points to Phoenix Coal Company, Inc. v. Commissioner (CA-2) 56-1 U.S.T.C. paragraph 9366, 231 F.2d 420 (2d Cir. 1956); Robinson, supra; and Bagley v. Commissioner, 105 T.C. 396 (1995), aff’d, 121 F.3d 393 (8th Cir. 1997).
LeFleur v. Commissioner, T.C. Memo. 1997-312, addresses the reallocation issue in a case involving claims for breach of contract, emotional distress, and punitive damages. In an out-of-court written settlement, the payment was allocated as $200,000 to contract, $800,000 to emotional distress, and $0 to punitive damages. The taxpayer excluded the $800,000 from income under IRC section 104(a)(2). The IRS disregarded the terms of the written settlement agreement and reallocated the $800,000 to contract/punitive damages. The Tax Court upheld the IRS reallocation. Referring to the settlement, the court stated that “the allocation did not accurately reflect the realities of the petitioner’s underlying claims.” In determining that the $800,000 was not excludable under IRC section 104(a)(2), the court stated: “In light of the facts and circumstances, we conclude that petitioner suffered no injury to his health that could be attributed to the actions of the defendants, and we are not persuaded that such injury was the basis of any payment to him….”
Agents Told How to Research
The IRS acknowledges that identifying taxpayers who have received large taxable lawsuit settlements can be a difficult process because a Form 1099 usually is not issued to the plaintiff. Most of the returns to be examined would not normally be selected through regular classification. The IRS tells its field auditors to check local newspaper articles and conduct courthouse research.
Newspaper articles provide a readily available source of information because large punitive damage verdicts generally make headlines. But, says the audit guide, this does not identify individuals who settle prior to a jury verdict.
To conduct courthouse research, the IRS agents are told to determine where civil lawsuits are originally filed in the jurisdiction, such as the circuit clerk’s civil division at the county courthouse. While there may be tens of thousands of civil cases filed in one year, the IRS guide notes that only a small portion of these cases will be punitive damage cases. Identifying punitive damage cases from this population can be a difficult process, according to the manual, which gives some techniques to identify these cases:
· Scan the style of the case (plaintiff versus defendant) at each courthouse. Most of the circuit clerks’ offices will be computerized, but some have handwritten records.
· Identify insurance companies and finance companies who are defendants in the cases. These are typically the types of companies being sued for punitive damages.
· Record the case file number.
· Review the case file. Most of the cases are settled out of court and dismissed with prejudice. This means the case has received final settlement and cannot be further litigated. Typically the dollar amount of the settlement is not noted in the file if the case is settled out of court . . . . Scanning the file is one of the most important techniques to become familiar with the type of lawsuit filed. Suits which seem to have non-physical damages (fraud, negligence, misrepresentations, etc.) are to be given priority.
· Review cases which are large in size. This tends to indicate that the lawsuit was in process for an extended period of time, and this could be an indication of a large settlement.
The IRS audit guide goes on with instructions for obtaining information from the defendant insurance companies, voluntarily or by summons, if necessary. This article does not purport to give tax advice.