Remaining tax opportunities in lawsuits and settlements.

Some of the most appealing tax planning opportunities relating to lawsuits and settlements disappeared when Congress amended Sec. 104(a) in 1996, generally eliminating the exclusion from gross income for compensatory damages received on account of a nonphysical personal injury or sickness and for all punitive damages. (See Tax Clinic, "Taxation of Personal Injury and Sickness Awards," TTA, May 1997, p. 280.) However, there is still a broad range of possible tax results when claims are litigated or negotiated.

Character of Litigation Payments

The character of payments from litigation or claims depends on the nature of the claim giving rise to the payments (Gilmore, 372 US 39 (1963)). This rule applies to both litigation awards and settlement proceeds and affects both payor and payee (Longino Estate, 32 TC 904 (1959)). Claims can be based on rights that would give rise to ordinary income (such as lost wages or business profits), capital gains (such as an asset's purchase or sale) or nontaxable income (such as personal physical injury compensatory damages or certain life insurance proceeds). In addition, in cases involving capital assets, a payment may be treated as a nontaxable return of capital, generally resulting in a reduction of the asset's basis rather than current taxable income (Rev. Rul. 81-277). Under Gilmore's origin-of-the-claim doctrine, the character of legal fees and expenses also follows the nature of the claim.

It is entirely possible for a payment to create an ordinary deduction for the payor without generating ordinary income to the payee. For example, a brokerage business may negligently cause a customer to lose part of the gain that should have been realized on an asset's sale. In this event, the recovery should be characterized as a capital loss to the plaintiff but as an ordinary business expense to the defendant; see, e.g., Letter Ruling 9550011. Such "win-win" characterizations may provide an economic benefit that can help bridge the gap between two sides in a negotiation.

Supporting Allocation of Payments to Desired Categories

Allocation of payments depends on all applicable facts and circumstances. The strongest possible evidence of the facts is an allocation made in the settlement agreement or judgment. Taxpayers should be very strongly encouraged to make such an explicit allocation whenever practicable. Of course, such an allocation will be respected only if it is reasonable; see, e.g., Phoenix Coal Co., 231 F2d 420 (2d Cir. 1956).

In some situations, there is no such explicit allocation--either because the parties' counsel omit an allocation or because the parties wish to take differing positions and thus cannot agree. If agreement appears unlikely, it may be tactically advisable not to raise the issue of allocation to avoid the risk of an explicit allocation that is unfavorable. In those circumstances, the IRS will look to other evidence, including the filed complaint, the defendant's answer and other documents or actions showing the parties' intent. For this purpose, the most persuasive evidence often will be found in the complaint, if any.

In Rev. Rul. 85-98, the Service allowed an allocation based on the amount claimed with respect to each count of the complaint, because these amounts "bore a reasonable relationship to what a jury might be expected to award." Of course, if some claims are stronger than others or other facts conflict with what is found in the complaint, this methodology is suspect.

Because it is never possible to know whether the parties will ultimately agree on an explicit allocation of a settlement payment, the tax adviser should work with the client's counsel to ensure that the record establishes the facts and circumstances needed to support the desired tax treatment--from the very beginning of any litigation or potential litigation. Consequently, the time to begin this process is with the very first communication that relates to the claim.