Tax Court specifies conditions for accepting settlement allocations.

The Tax Court recently ruled in McKay, 102 TC No. 16 (1994), that, in determining tax consequences, it would follow the express allocation of claims in a written settlement agreement if the parties reached the settlement as a result of "bona fide, arms-length, adversarial negotiations." However, the court also ruled that it is not bound by a written settlement agreement, even if approved by a trial court, if the agreement is not the result of such negotiations. Also, the Tax Court pointed out that it is not bound by any factor that does not reflect the "true substance" of the taxpayer's claim or claims.

Although McKay involved a Sec. 104(a)(2) allocation, it arguably applies to all written settlement allocations between excludible and taxable claims. Sec. 61(a) includes in gross income all income from whatever source derived. Sec. 104(a)(2) excludes "the amount of all damages received (whether by suit or agreement ... on account of personal injuries." This exclusion has been interpreted by the Supreme Court to cover tortlike personal injury claims, whether physical or nonphysical. To be tortlike, the Supreme Court ruled that the claim must provide for a broad range of compensatory damages and, where appropriate, punitive damages. The Court contrasted a claim that allowed only back pay with one that allowed back pay, future pay, emotional distress, and pain and suffering. The first was taxable, while the second was excludible. Also, breach of contract claims are not tortlike and are therefore taxable under Sec. 61(a)(1). (For claims made after July 10, 1989, punitive damages for nonphysical injuries are taxable due to legislative changes to Sec. 104(a)(2).

In 1979, McKay was recruited by Ashland for an executive position. He was reluctant to work for Ashland because he knew of prior questionable practices by Ashland. McKay accepted the position only after assurances by senior Ashland officials that the company had stopped such practices. However, Ashland continued these practices. The IRS and the Securities and Exchange Commission (SEC) conducted inquiries into the practices, and McKay testified. Ashland terminated him in 1983, and he sued the company.

At the time of trial, the suit consisted of the following charges: wrongful discharge in violation of public policy, breach of contract for firing McKay without just cause, violations of the Racketeer Influenced and Corrupt Organizations Act (RICO) and punitive damages. The public policy violations consisted of firing McKay both for refusing to pay a bribe to a foreign official and for refusing to commit perjury in his testimony to the Service and the SEC. The jury awarded McKay $1.6 million in lost compensation, $12.8 million in future damages, triple damages of $43 million under RICO and $1.25 million in punitive damages. The jury did not indicate whether the lost compensation and future damages were from breach of contract or public policy claims. After hostile negotiations, the parties settled for $14.29 million plus legal fees. The written settlement agreement allocated $12.25 million to "wrongful discharge tort claim" and $2.04 million to "contract breach claim." The settlement specified that the tort claim was a tortlike, personal injury claim excludible under Sec. 104(a)(2) and the contract claim was taxable under Sec. 61(a). Nothing was allocated to the RICO or punitive damages claims; Ashland insisted that no amounts be allocated to these claims. McKay agreed to the settlement because of the risks he would face on appeal and the threat of prolonged litigation. A Federal District Court closely involved with the negotiations approved the settlement, after finding that the allocations fairly reflected the relative value of McKay's claims.

The Tax Court had ruled in previous Sec. 104(a)(2) cases that, in a written settlement, it is the nature of each claim settled that determined if the exclusion applied. The taxpayer must prove which claims were settled and that they were tortlike personal injury claims to obtain the Sec. 104(a)(2) exclusion. If the settlement is unclear as to which claims were settled (as in a general release of all claims), the Tax Court looks to the payor's intent in making the payment by examining all of the facts relevant to the controversy that led to the settlement. These facts include the claims, arguments and testimony of both parties. If a lawsuit was filed, the Tax Court also examines the pleading and any jury awards and/or court judgments. If there is no settlement, the court will follow the allocation among claims in the trial court verdict.

McKay argued that the settlement allocations should be followed in determining the tax consequences. The IRS contended that the allocations should be ignored, since the parties were not adverse. The Service reasoned that, since Ashland could deduct the payments to McKay regardless of the allocation between tort and contract claims, Ashland was indifferent to the allocation. Therefore, the parties were not adverse as to the tax consequences in negotiating their settlement. The Tax Court rejected this argument; although the deductibility of the payments may be a factor in determining if the parties are adverse, it is not controlling. The IRS also argued that McKay's claims were purely contractual; the award of back and future pay indicated a contract claim and the public policy claim was based on job performance. The court rejected these arguments, emphasizing that it would not ignore the terms of the settlement agreement if the agreement was the result of bona fide arm's-length negotiations. Additionally, the court pointed out that the settlement was consistent with the law of the state in which McKay resided on termination of employment, which contained contractual and tort claims.

The Tax Court ruled that it would follow the settlement's allocation because McKay and Ashland were adversaries; the tort claim was excludible and the contract claim was taxable. The court found McKay wanted a large settlement and to punish Ashland. Ashland wanted a small settlement, with no amount allocated to the RICO or punitive damages claims. The Tax Court held that the settlement reflected the entire record, and that the large amount allocated to the tort was consistent with the jury verdict. Therefore, this allocation provided the clearest indication of Ashland's intent in making the payment to McKay.

The Tax Court distinguished Robinson, 102 TC No. 7 (1994), in which it ignored the settlement agreement even though that agreement was approved by the trial court. In Robinson, the payor's only concern was the $10 million amount of the settlement, not its allocation. Robinson assumed complete control over the settlement allocations. To minimize taxes, he allocated 95% to mental anguish and 5% to lost profits, resulting in a $9.5 million exclusion. The trial court then accepted the settlement without scrutiny. The Tax Court ruled that it was "uncontested, nonadversarial, and entirely tax motivated and, therefore, did not accurately reflect the underlying claims. "

McKay provides the criteria the Tax Court will use in deciding whether to accept express allocations among excludible and taxable claims in a written settlement. Even though the lost compensation and RICO claim components of the jury verdict arguably did not qualify for the Sec. 104(a)(2) exclusion, the Tax Court ruled that the settlement was binding for tax purposes because the settlement resulted from "bona fide, arms-length, adversarial negotiations." McKay is the first case to apply this standard and allow the allocations between excludible and taxable claims specified in the settlement agreement. Practitioners should advise clients that a settlement must meet this standard if the Tax Court is to honor it. Implicit in this standard is a requirement of consistency in the taxpayer's claims from the beginning of the controversy, through the negotiations, to the settlement. However, as shown in McKay, the parties have some freedom in the negotiation process as long as they are truly adverse. The more the allocations in the settlement deviate from the facts leading up to it, the stronger the proof required by the Tax Court that the parties are adverse.

From Peter C. Barton, CPA, MBA, J.D., Associate Professor of Accounting, and Clayton R. Sager, Ph.D., Professor of Accounting, University of Wisconsin-Whitewater, Whitewater, Wisc.