Taxation of Commercial Litigation

Settlements and Judgments

October 13, 2011

Kevin KaiserCo-panelist

Outline

• Recognition of income for receipt of settlements and judgments

• General rules for deductibility of settlements, judgments, fines and penalties

• Special rules for contingent fees

• Deductions for legal fees

Taxation of Commercial Litigation Settlements and Judgments

How Is The Receipt of Income from a Settlement or Judgment Taxed?

Taxable or Nontaxable?

Capital Gain or Ordinary Income?

Tax Treatment of Commercial Litigation Income

• Origin of the Claim Doctrine

o What was the recovery paid in lieu of?

o The recovery should be taxed in the same manner as the item for which is intended to substitute.

U.S. v. Gilmore (Sup. Ct., 1963), Origin of the claim doctrine

Tax Treatment of Commercial Litigation Income

• Origin of the claim

o Based on pleadings

o Based on complaint

o Based on settlement agreement

Tax Treatment of Commercial Litigation Income

• Origin of the claim

o Lost profits = Ordinary income

o Lost capital = Capital gain income E.g., injury to goodwill

Tax Treatment of Commercial Litigation Income

Tax considerations should be addressed in advance, BEFORE a patent infringement, antitrust or other business dispute is resolved by an agreement or judgment directing the infringer to pay a sum to the winner.

Tax Treatment of Commercial Litigation Income

• Inco Electroenergy v. Commissioner (TC, 1987) Trademark and patent case

o Amounts received in settlement of trademark dispute and injury to goodwill were capital gain income

o Trademark and related goodwill are capital assets of the business

• Taxpayer should make allocation clear in pleadings, complaint, settlement or other evidence to guide the tax treatment (not binding on the IRS, but persuasive)

Tax Treatment of Commercial Litigation Income

• Freda v. Commissioner (CA-3, 2011) Patent and trade secret caseo Taxpayers were shareholders of S-corporation that developed

patented process for packaging and distributing uncooked sausage. Entered into contract to supply sausage to Pizza Hut.

o Taxpayers alleged that Pizza Hut compromised their patented process and trade secrets. Settlement was reached.

o Amounts paid to settle a misappropriation of trade secrets claim was taxable as ordinary income, not as capital gain.

• Taxpayer maybe could have made allocation clear in pleadings, complaint, settlement or other evidence to guide the tax treatment (not binding on the IRS, but persuasive)

Personal Injuries

• Money damages received for personal injuries are taxable unless received "on account of personal physical injuries or physical sickness"

• What does "physical" mean? What about, o Emotional distresso Reputational harmo Age, Race, Sex discriminationo Americans with Disabilities (ADA)o Wrongful imprisonment

Contingent Fees (and contingent fee "income")

• If a plaintiff receives a recovery and simultaneously pays fees to his contingent fee lawyer, is the client taxed on the net or the gross amount ?

• The client has gross income on the entire recovery even if the contingent fee lawyer is paid directly by the defendant and the client receives only a net check. Commissioner v. Banks (Sup. Ct., 2005)

• Special "above the line" deduction allowed for contingent fees paid in connection with certain unlawful discrimination

Taxation of Commercial Litigation Settlements and Judgments

Can a Settlement or Judgment Payment of Damages be Deducted?

Taxation of Settlements and Judgments

• General Rule of Deductibility – current rules

o The payment of a settlement or judgment is deductible if the taxpayer can prove the expense arises from the active conduct of a trade or business

o Fines and penalties (i.e., payments made to a government entity) are generally not deductible

o Public policy considerations should not control the availability of a deduction for settlements or judgments

Taxation of Settlements and Judgments

• Business Deductions – What is ordinary and necessary?

o Ordinary – A business would commonly incur the expense under the circumstances. Repeated occurrence not required. May be irregular or once in a business’s life, e.g., product liability.

o Necessary – Expense is appropriate and helpful.

o Note – Expenses must be reasonable. Attorney’s fees and settlement amounts are usually not challenged. Parties are dealing at arm’s length and litigation, by its nature, is adversarial.

Taxation of Settlements and Judgments

Codified policy based deductions. Four types of expenditures denied deductions by Congress in 1969:

1. Fine or similar penalty paid to a government for the violation of any law – section 162(f)

2. Two-thirds treble damages payments under the antitrust laws following a related criminal violation – section 162(g)

3. Deductions for bribes paid to public officials – section 162(c)(1)

4. Other unlawful bribes or kickbacks – section 162(c)(2)

Taxation of Settlements and Judgments

• Section 162(f)o No deduction shall be allowed under section 162(a) for any

fine or similar penalty paid to:

– U.S. government or State government

– Government of foreign country

– A political subdivision of, or corporation or other entity serving as an agency or instrumentality of state or federal government

Taxation of Settlements and Judgments

• Section 162(f)o Fine or similar penalty includes an amount:

– Paid pursuant to a conviction

– Paid as a civil penalty imposed by Federal, state, or local law

– Paid in settlement of the taxpayer’s actual or potential liability

Note – does not include legal fees or court costs

Taxation of Settlements and Judgments

• What’s not included in the section 162(f) disallowance?

o Settlements and judgments

Punitive damages

Compensatory damages

Taxation of Settlements and Judgments

Colt Industries, Inc. v. U.S. (CA-Fed Cir., 1989)

• Colt violated Clean Air and Water Act. EPA imposed civil penalties of $1.6 million

• Deducted on 1979 tax return as ordinary and necessary business expense

• Service and Claims Court denied deduction under section 162(f). Penalty paid to government

Taxation of Settlements and Judgments

Talley Industries, Inc. v. Commissioner (CA-9, 2001)• Talley mischarged and over charged the government (US Navy)

for work on government contracts. Company accused of fraud and filing false claims

• Talley paid $2.5 million as restitution under plea bargain and deducted the payment

• Ninth Circuit allowed $1.56 million deduction, an amount equal to the estimated government losses (reimbursement/restitution)

• $940,000 was disallowed as a fine

Taxation of Settlements and Judgments

Jenkins v. Commissioner (TC, 1996)

• Company fined by North Carolina and Virginia for producing and selling fertilizer deficient in certain chemicals

• Tax Court found that penalty was imposed to compensate consumers and was not viewed as punitive. “Penalty” held to be deductible

Taxation of Settlements and Judgments

Legal Fees - A short summary of the tax treatment of paying legal fees

• Can deduct if they arise out of a trade or business;

• Can deduct (subject to limits and thresholds) if they arise out of an investment activity or something undertaken for profit;

• Can deduct (subject to limits and thresholds) if they relate to tax advice;

• Must capitalize if they relate to capital assets, either held for investment or use in a trade or business;

• Cannot deduct at all (i.e., no tax benefits) if they relate to personal matters.

Q&A