Presentation on theme: "Jared D. Mobley Practical Tips to Serving as Tax Counsel in Lawsuit Settlements & Judgments May 24, 2009 Jared D. Mobley K&L Gates LLP Charlotte, North."— Presentation transcript:
Jared D. Mobley Practical Tips to Serving as Tax Counsel in Lawsuit Settlements & Judgments May 24, 2009 Jared D. Mobley K&L Gates LLP Charlotte, North Carolina
2 Jared D. Mobley Summary of Presentation 1)Tax Treatment of Payee’s Recovery Payments 2)Taxation of Payee’s Attorney Fees 3)Tax Treatment of Payor’s Expenditures, including Attorney Fees 4)Key Principles
3 Jared D. Mobley 1)Tax Treatment of Payee’s Recovery Payments
4 Jared D. Mobley Tax Treatment of Payee’s Recovery Payments Characterizing a Recovery Payment for Tax Purposes General Rule Origin of the Claim Doctrine: The federal income tax characterization of a settlement or judgment payment will be determined by reference to the origin and nature to which the claim relates. See, e.g., United States v. Gilmore, 372 U.S. 39 (1963) and Anchor Coupling Co. v. United States, 427 F.2d 429 (7th Cir. 1970). One may ask, “in lieu of what was the settlement or judgment paid?”
5 Jared D. Mobley Tax Treatment of Payees Recovery Payments Characterizing A Recovery Payment For Tax Purposes Taxable Non-taxable
6 Jared D. Mobley Tax Treatment of Payee’s Recovery Payments Taxable Payments Ordinary Income (maximum federal tax rate of 35%) Compensation (subject to ordinary income tax rates, plus income tax withholding and employment taxes) Capital Gain (current maximum federal tax rate of 15% for individuals, estates & trusts)
7 Jared D. Mobley Tax Treatment of Payee’s Recovery Payments Wages Income tax withholding required Employment Tax: Social Security Tax (6.2%, 2009 cap of $106,800) Employment Tax: Medicare Tax (1.45%, no cap) Employer and Employee each pay an equal share of employment taxes
8 Jared D. Mobley Practice Point #1 NC Special Deduction for Severance N.C. Gen. Stat. § (b)(11) -- $35,000 state income tax deduction for severance wages Must be permanent and involuntary termination due to no fault of employee No N.C. income tax withholding required for qualifying severance wages Refer to Directive PD
9 Jared D. Mobley Practice Point #2 Non-Wage Claims in “Employment” Lawsuits Certain damages paid in employment lawsuit, although taxable, may not be “wages” such as: Emotional distress and tort-like recoveries. Interest and legal fees under fee-shifting statutes. See Rev. Rul and TAM When representing the employer, be extremely careful given withholding and remittance obligations and responsible person liability. The ultimate tax burden often fall on the employer.
10 Jared D. Mobley Tax Treatment of Payee’s Recovery Payments Non-Taxable Payments Damages (other than Punitive Damages) Received “On Account of Personal Physical Injuries or Physical Sickness.” IRC §104(a)(2). Recoveries Relating to Return of Capital or Basis. See PLR (recovery for faulty construction of residence).
11 Jared D. Mobley 2) Taxation of Payee’s Attorney Fees
12 Jared D. Mobley Tax Treatment of Payee’s Attorney Fees GENERAL RULE The tax treatment of legal fees paid by the parties in a settlement or judgment generally is determined by reference to the nature and tax characterization of the settlement or judgment payment. Where the settlement or judgment payment is allocated among more than one legal claim, the tax treatment of legal fees should be proportionately allocated in the same manner.
13 Jared D. Mobley Tax Treatment of Payee’s Attorney Fees Example 1: Individual Tort Recovery Macon receives $100,000 in a lawsuit, and the parties properly characterize ½ of the payment as received “on account of physical injuries” and ½ of the payment as wages. If Macon pays $30,000 of legal fees, then $15,000 of them would not be deductible or subject to capitalization (the portion allocable to the tax-free recovery) and $15,000 would be deductible (the portion allocable to wages).
14 Jared D. Mobley Tax Treatment of Payee’s Attorney Fees Example 2: Employment Recovery Macon recovers $360,000 in settlement of an employment discrimination lawsuit against her employer. Macon owes her lawyer, $160,000 for legal fees, expenses and costs associated with the lawsuit. What is Macon’s federal income tax liability (assuming no other income or deductions)?
15 Jared D. Mobley Tax Treatment of Payee’s Attorney Fees Macon’s Expectation – Legal Fees Deductible Gross Income$360,000 Legal Fees Deduction - 160,000 $200,000 Effective Tax Rate x 45% $ 90,000(IRS) After-Tax Amount$110,000(Macon)
16 Jared D. Mobley Tax Treatment of Payee’s Attorney Fees IRS Expectation - Misc. Itemized Deduction The $160,000 of attorney fees is a “miscellaneous itemized deduction” under IRC §68. As such, it is subject to 3 limitations: (i) deductible only to extent it exceeds 2% of AGI, (ii) Pease limitation (subject to special rules in 2009 and 2010), deduction reduced in an amount equal to the lesser of (a) 3% of the excess of AGI over an inflation- adjusted amount & (b) 80% of certain itemized deductions), and (iii) AMT Disallowance. As a result, attorney fees deduction is disallowed, effectively.
17 Jared D. Mobley Tax Treatment of Payee’s Attorney Fees IRS Expectation – Misc. Itemized Deduction Gross Income$360,000 Legal Fees Deduction - 0(Attorney Fees) $360,000 Effective AMT Rate x 30% $ 108,000 After-Tax Amount$92,000(Macon) (IRS)
18 Jared D. Mobley Tax Treatment of Payee’s Attorney Fees Summary of Net Recovery Proceeds Recovery$360,000$360,000 Attorney Fees- 160, ,000 Tax Liability- 90, ,000 $110,000$92,000 Macon’s Expectation IRS Expectation
19 Jared D. Mobley Tax Treatment of Payee’s Attorney Fees Macon’s Position Bona Fide Transfer of Rights to Lawsuit Recovery to Attorney Joint Venture or Partnership Between Client and Attorney Attorney has Ownership in Lawsuit (via certain state’s attorney-lien statute) IRS Position Assignment of Income Doctrine (Lucas v. Earl, fruit vs. tree)
20 Jared D. Mobley Tax Treatment of Payee’s Attorney Fees U.S. Supreme Court Decision Banks/Banaitis 543 U.S. 426 (2005) IRS Wins Assignment of Income Doctrine Applies Key Ruling:Attorney-Client Relationship is a Principal- Agent Relationship
21 Jared D. Mobley Tax Treatment of Payee’s Attorney Fees American Jobs Creation Act of 2004 Partial Legislative Fix (IRC § 62(a)(20)): Above-the-Line Deduction Allowed for Certain Employment-Related Claims (effectively removes miscellaneous itemized deduction and AMT problem for certain claims). Applies to “Unlawful Discrimination” Claims. IRC §61(e). Applies to Amounts Paid after October 22, 2004 “With Respect to any Judgment or Settlement Occurring after Such Date.”
22 Jared D. Mobley Tax Treatment of Payee’s Attorney Fees Defamation Conversion Breach of Fiduciary Duty Libel Invasion of Privacy Condemnation Interest? Punitive Damages? Denial of Coverage Tortuous Interference Claims Falling Outside AJCA of 2004
23 Jared D. Mobley Practice Point #3 IRC § 61(e) The IRS and Courts have not provided guidance on the scope of “unlawful discrimination” and the above the line deduction under IRC § 62(a)(20). If representing the payee, will the payee have a better, after-tax and after-attorney fee payment position if the full damage award is “wages” instead of emotional distress or other taxable, non-wage categories?
24 Jared D. Mobley 3)Tax Treatment of Payor’s Expenditures, including Attorney Fees
25 Jared D. Mobley Tax Treatment of Payor’s Expenditures GENERAL RULE The tax treatment of expenditures paid by the payor in a settlement or judgment generally is determined by reference to the underlying nature of the claims related to the settlement or judgment (again, the origin of the claim doctrine).
26 Jared D. Mobley Tax Treatment of Payor’s Expenditures Characterizing Expenditures For Tax Purposes Deductible expense Capital expenditure Non-deductible, non-capital expenditure
27 Jared D. Mobley Tax Treatment of Payor’s Expenditures Deductible Expenses Expenses incurred in payor’s trade or business, including punitive damages (IRC § 162) Expenses incurred in a transaction entered into for profit (IRC § 212) Individuals subject to miscellaneous itemized deduction and AMT limitations for IRC § 212 expenses
28 Jared D. Mobley Tax Treatment of Payor’s Expenditures Capital Expenditures (IRC § 263) Expenses for “defending or perfecting title to property” Expenses that “add to the value, or substantially prolong the useful life, of property” Expenses attributable to the purchase or sale of a capital asset
29 Jared D. Mobley Tax Treatment of Payee’s Expenditures Non-Capitalizable, Non-Deductible Expenditures for Tax Purposes No deduction is allowed for personal expenses. No deduction is allowed for any fine or similar penalty paid to a government for the violation of any law. IRC §162(f). No deduction is allowed for payments relating to illegal kickbacks, illegal bribes or other illegal payments. IRC §162(c). No deduction is allowed for 2/3 of payments made as a result of violations of certain antitrust laws. IRC §162(g).
30 Jared D. Mobley Practice Point #4 IRC § 162(f) Fines Restitution Payments Outside of IRC § 162(f). Compensation Payments Likely Outside of IRC § 162(f). Government officials are not coordinating government settlements with IRS. Sen. Grassley is scrutinizing these transactions.
31 Jared D. Mobley Practice Point #5 Tax Reporting Wages – Report on IRS Form W-2. Taxable Non-wages – Report on IRS Form 1099-MISC. Non-Taxable - No Reporting required. Payment of Legal Fees - Report on Form 1099-MISC.
32 Jared D. Mobley 4)Key Principles
33 Jared D. Mobley Key Principles Best Evidence Available The tax treatment of a payment of a settlement or judgment must be allocated using the “best evidence available.” The determination of the best evidence available requires an analysis of the facts and circumstances relating to the dispute. For example, the best evidence available for a pre-trial settlement likely will be the complaint because it will often be the only document describing the claim (or claims).
34 Jared D. Mobley Practice Point #6 Pre-Judgment Settlements Allocations should not be made to claims in the complaint that are not likely to be successful (“throw-in claims”) if the case would have gone to full trial and judgment.
35 Jared D. Mobley Key Principles Burden of Proof The payee of a settlement or judgment bears the burden of proving that the payment (or portion thereof) is a taxable or non-taxable payment. The payor of a settlement or judgment has a similar burden of proof.
36 Jared D. Mobley Practice Point #7 Shareholder Lawsuits If cases where the entity and its key equity holder(s) both are named in the lawsuit, one must determine whether the payment is for the benefit of (i) the entity or (ii) the equity holder (or a combination thereof).
37 Jared D. Mobley Key Principles IRS Review of Recovery Payment The courts and Internal Revenue Service will generally respect the allocations in a settlement agreement provided that such settlement is entered into in an adversarial context, at arm’s length and in good faith.
38 Jared D. Mobley Practice Point #8 Non-Arms Length If the parties are not sufficiently “tax adverse” as to a portion of a recovery, make allocations to that portion very carefully. For example, allocation to non-wage, damage claims economically benefit both the employer and employee (due to employment tax savings).
39 Jared D. Mobley Key Principles Failure to Characterize Recovery Payments The IRS and courts do not give much deference to the tax characterization of a settlement or judgment payment if the characterization is made after the resolution of the non-tax issues of the lawsuit. The parties must address the tax consequences of a settlement or judgment payment at some point. If the parties fail to address them at the time that the non ‑ tax issues are resolved, then their tax return preparers will have to address the tax consequences when the applicable tax returns are filed for the year of the payment or tax reporting is made (e.g., Form 1099, Form W-2) for such year.
40 Jared D. Mobley Key Principles Settlement and Judgment Tax Provisions The language in a settlement agreement or judgment will often have a substantial effect on the tax treatment of payments made thereunder.
41 Jared D. Mobley Key Principles Settlement and Judgment with Multiple Claims In a lawsuit with multiple claims, the origin and nature of each claim must be determined and spelled out in the settlement or judgment.
42 Jared D. Mobley Key Principles Frequency of IRS Audits The IRS has been most diligent in its scrutiny of the tax characterization of settlements and judgments. In 2001, the IRS released a Market Segment Specialization Program training guide covering lawsuit awards and settlements to train their auditors on the issues.
43 Jared D. Mobley Practice Point #9 The Authoritative Guide Robert W. Wood, Taxation of Damage Awards and Settlement Payments (3d ed, 2004 with 2008 supplement).
44 Jared D. Mobley IRS CIRCULAR 230 NOTICE: In order to comply with certain IRS regulations regarding tax advice, we inform you that, unless expressly stated otherwise, any tax advice contained in this communication (including any enclosures) is not intended or written to be used, and cannot be used, for purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.