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Allocations in personal injury settlements greatly affect tax treatment of proceeds.

Sec. 104(a)(2) excludes from gross income the amount of any damages received, whether by suit or settlement, for personal injuries or sickness, including libel, slander and defamation (which are considered personal injuries). Most lawsuits include a number of different claims. The plaintiff will ask for compensatory damages to cover the actual injury, lost wages, medical expenses and a host of other causes of action. Whenever possible, a claim for punitive damages will also be included. The amount of punitive damages stated in the suit will usually be a multiple of the actual damages claimed. Often, however, a jury will simply award one lump-sum amount for all damages. And while personal injury damages are excludible from gross income, punitive damages are excluded only if in connection with a case involving physical injury or physical sickness (Sec. 104). Most lawsuits are settled, many without any tax planning or no tax planning until the final settlement agreement is drafted. Proper tax planning from the earliest stages of the legal process can maximize the after-tax recovery for clients.

A settlement document will often contain language that the payments are being made exclusively for personal injury-type damages. It will state that no punitive damages are being paid, regardless of the amount alleged in the original suit. Labeling a breach of contract settlement as being exclusively for personal injury is not adversarial; the business defendant will be able to deduct the settlement payment regardless of its characterization. By settling with "after-tax dollars," can both sides come out ahead at the expense of the IRS?

Courts look to the "origin and character of the claim asserted" in deciding if a settlement payment falls under the Sec. 104 exclusion (Kurowski, TC Memo 1989-149). The "nature of the claim that was the actual basis for settlement rather than the validity of such claim" is the key (Downey, 97 TC 150 (1992)). To make this determination, the courts look at the pleadings, evidence introduced at trial, the settlement agreement and the intent of the payor. "In a given case, any one of these factors may be ultimately persuasive or ignored" (Threlkeld, 87 TC 1294 (1986)). The test boils down to the "facts and circumstances" and the burden of proof is on the petitioner (Seay, 58 TC 32(1972)).

In Knuckles, TC Memo 196433, the petitioner's attorney tried to turn a contract action into a personal injury action at settlement time by filing a second complaint stating tort-type causes of action. The court saw through this tactic, saying, "the petitioner's insistence upon settlement based on a tort claim for personal injury was an afterthought brought into being by the possible tax advantage which might result." The court had harsher words for a plaintiff that attempted to settle with "after-tax" dollars in O.S.C. Corp., TC Memo 1982-280. The court decided that the allocation of the settlement to a personal injury claim "was an afterthought devised by petitioner's attorney to enable the parties to reach an acceptable settlement figure...[b]y in effect agreeing that the dollars received would be after-tax dollars .... We decline to sanction such a transparent attempt to avoid income taxes legally due."

A settlement agreement cannot guarantee favorable tax treatment if it contradicts the record (Metzer, 88 TC 834 (1987)); it is proof, but not conclusive proof. The record must show that a personal injury claim was an integral part of the lawsuit. and not just an afterthought. Evidence supporting any personal injury claim must be presented. And the sooner it is presented, the more weight it carries.

How will settlement proceeds be classified when the agreement makes no allocation and the lawsuit had both personal injury and nonpersonal injury claims? What if the personal injury was not of a physical nature? Does any portion of the settlement have to be allocated to the punitive damages asked for in the complaint? In Rev. Rul. 85-98, the IRS took a straightforward, mathematical approach in answering these questions when allocating a libel settlement between punitive and compensatory damages. The Service examined the complaint and determined that "since the amount of punitive damages relative to compensatory damages requested bore a reasonable relationship to what a jury might be expected to award," that ratio would be applied to the settlement amount.

The obvious problem with this approach is that if the attorney for the plaintiff asks for an outrageous punitive damage amount in a nonphysical personal injury action, any settlement would be mostly taxable. While in the real world any settlement would be documented, the revenue ruling made no reference to a written settlement agreement and what weight (if any) it would be given. And how exactly does one determine what "a jury might be expected to award"? High punitive damage claims should be avoided until late in the legal proceedings so as not to maximize the taxability of an early settlement. Likewise, if a lawsuit can be framed in a personal injury context originally, an early settlement could be tax free. The suit could be amended later to include nonpersonal injury claims.

The courts have focused on the "intent of the payor" when the settlement agreement is silent or lacks express language on allocations between claims. In Eisler, 59 TC 634(1973 ), the court acknowledged that no exact determination could be made and that "the most that can be expected of us is the exercise of our best judgment based upon the entire record .... [W]e did endeavor to make as close an approximation as we could with regard to what we considered to be the respective weights that the parties in fact placed upon the relative values of their respective claims." In other words, we are back to the "facts and circumstances" test.

What happens if a verdict was reached at the trial court level and a settlement was made rather than going through the appeals process; how is the payment allocated? This situation occurred in Miller, 914 F2d 586 (4th Cir. 1990L rev'g and rem'g 93 TC 330 (1989). The taxpayer had won a jury verdict in a defamation case and was awarded compensatory and punitive damages. The taxpayer settled for a lesser amount, but the settlement agreement was silent on any allocations. The Tax Court had let the taxpayer exclude the entire settlement, even the punitive damages. The Fourth Circuit reversed and remanded the case to the Tax Court to allocate the settlement between compensatory and punitive damages. The court offered alternative allocation methods, including considering the ratio of punitive to compensatory damages awarded in the original judgment. However, the Court of Appeals deemed the matter to be "quintessentially appropriate for the Tax Court." Hence, once again, there is no fixed rule (although one can find support for this ratio type of allocation).

The bottom line is that if a settlement document, consistent with the underlying facts, does not expressly state the allocations between claims, the intent of the payor will have to be determined. Fortunately, few payors ever intend to pay punitive damages. Unfortunately, this determination is highly subjective and leaves one open to second guessing by the IRS and the courts. Early tax planning in the litigation process can help mitigate this problem. From Gary S. Colton, LD., White, Petrov, McHone, P.C. Houston, Tex.
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Author:Colton, Gary S.
Publication:The Tax Adviser
Date:Aug 1, 1992
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