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Defense strategy: tax pre-judgement interest.

by Bruce A. Truex Taxing pre-judgment interest awarded in personal injury cases may help defendants settle particular cases. Pursuant to SS104(a) of the Internal Revenue Code, personal injury awards are tax exempt. The interest received from a personal injury judgment, however, is included in gross income under SS61(a)(4) and is not exempt from taxation. This has uniformally been the position of the Internal Revenue Service. In fact, decisions from as far back as the 1930s, including Riddle v. Commissioner, 27 BTA 1939 (1933), have held that judgment proceeds designated as interest must be included in income.

In a pending Michigan case, the IRS contended that $1.3 million of interest included in a $2.3 million verdict was subject to tax. It also assessed penalties against the taxpayers of 25 percent of the unpaid tax plus interest on the unpaid tax. However, the government was willing to permit the taxpayer to deduct from the interest income the portion of the attorney's fee that generated the interest income. A negotiated settlement, which does not specifically identify interest, unlike a verdict with interest, may not be subject to tax. In McShane v. Commissioner, 53 TCM 1987151, the taxpayer-plaintiffs were injured in a gas explosion and sued the wrongdoer. After a trial by jury, verdicts were returned against the defendants for $1.275 million. Under state law, the plaintiffs were entitled to interest on the verdict from the date suit was filed. Following the verdicts, the parties began settlement negotiations. As a result of the negotiations, and prior to the filing of the appellate brief, the parties settled. The settlement agreement provided that lump sums were to be paid to the plaintiffs without costs and interest. The court also noted that the intentions of the parties were consistent with the payment of no costs or interest. The total settlement, nonetheless, was equal to the total of the verdicts plus statutory interest from an arbitrary date less a 5 percent discount.

When the plaintiffs filed their annual tax returns, they did not report any portion of the settlement award as interest income. The IRS contended the settlements were composed of two clearly distinguishable amounts: the jury verdicts from the personal injury claims and the amount of statutory interest less a 5 percent discount. The plaintiff-taxpayers argued that the settlements consisted entirely of damages for the personal injuries which were excluded from gross income under SS104(a). It was undisputed that any statutory interest would be taxable under SS61.

The Tax Court held that the settlements were personal injury damages properly excluded from the plaintiffs' taxable income. From a defense standpoint, the IRS rulings may be employed as a negotiating tactic. In a liability case, a plaintiff will normally demand a figure equal to his damages plus 1 00 percent of the statutory interest incurred to date. Because the interest portion of the verdict will be taxed, the plaintiff should agree to a settlement equal to his damages plus an amount greater than 66 percent, but less than 100 percent, of the interest. (This assumes a maximum tax of 33 percent.) The plaintiff's settlement would then equal more than his after-tax recovery on the verdict. The defendant would benefit by paying less than 100 percent of the interest on the verdict. This approach may be a particularly effective means of settling post-verdict cases on appeal when the appellate issue is questionable. In such a situation the plaintiff's verdict plus interest would be fixed. if the plaintiff won the appeal, the net interest recovered by the plaintiff would be reduced by approximately 33 percent for taxes. If the plaintiff lost the appeal, he would recover nothing. As a consequence, the plaintiff should be willing to reduce his demand by some portion of the amount of the tax on the interest plus the legitimate value of the appellate issue. Thus, the IRS has provided the defendant with a tool which will encourage a plaintiff to settle rather than try liability cases and settle them for a reduced total payment by the defendant. Unfortunately, a plaintiff's attorney who is tempted to act in his own best interest to the detriment of his client may reject this settlement offer. A plaintiff attorney's fee is generally a percentage of the total recovery regardless of the tax consequences to his client. The attorney's fee would be the greatest if he obtained a verdict plus 100 percent of the interest. The attorney's fee would then be calculated as a percentage of a larger gross recovery. The client's net recovery, however, would be smaller. If this negotiation technique appears appropriate, the defendant should minimize his discussions with the plaintiff attorney concerning the tax consequences of the settlement. The McShane court, apparently in an attempt to reduce the likelihood of collusion between the defendant and plaintiff, arrived at three conclusions: The McShane settlement did not include interest because each agreement provided that the settlement was to be paid without costs and interest; the intentions of all parties as stated by their attorneys were consistent with the payment of no costs or interest; and the taxpayers and attorneys uniformally and honestly testified that the tax consequences of the settlements were not considered in negotiations, but instead the settlement amounts were arrived at solely from a consideration by each party of the risks it would be subjected to by continuing the appeal. The third McShane criteria makes the use of this negotiation technique more difficult. To the extent that taxation is discussed, it increases the likelihood that a tax court could at a later date deem a portion of the settlement taxable. The tax consequences of that determination, however, rests with the plaintiff. Moreover, the court did not state that any discussion of tax consequences would mandate that a portion of the settlement be deemed interest. Rather, it established the three criteria. It also indicated that an absolute failure to discuss the tax consequences meant that the settlement contained no interest. It did not state that any discussion of tax consequences meant the settlement figure contained interest. To minimize the tax consequence of the negotiations, the defendant should propose a settlement figure without discussing the taxable consequences. If the plaintiff is uninformed concerning the consequences of a verdict as opposed to a settlement, he should be counseled to review SS104 and SS61 of the code and then make his own decision.

If an inquiry is made at a later date regarding the settlement negotiations, a full disclosure should be provided. If a portion of the settlement is deemed to be interest, the plaintiff will simply have to pay the appropriate tax. Under no circumstances should a defendant enter into an agreement to falsify information about the negotiation process for the purpose of assisting the taxpayer in avoiding his taxes. Such an action could be deemed fraudulent. In reality, a negotiated settlement which allocates money to non-taxable claims has been a common practice in litigation for decades. Personal injury plaintiffs with wage-loss claims seldom, if ever, identify the portion of the wage-loss claim that would be subject to tax. In such situations a lump-sum settlement is reached, with the payment almost always designated by the plaintiff as recovery for pain and suffering or other non-taxable injuries. Negotiated settlements involving plaintiff's potential for an interest recovery are no different. They are simply potentials that may or may not occur and are subject to negotiation by each party. There is no actual interest because a case on appeal may be won, lost or remanded. A multitude of factors affect every negotiation, and the tax consequences are clearly a factor that should be considered by any attorney who properly represents his client. In the appropriate case, the tax code may assist defense attorneys in effectively representing their clients and minimizing the total payment to the plaintiff. Safety Week Coming The American Society of Safety Engineers will educate workers and employers about drug and alcohol issues in the workplace during National Safety Week June 24-30. The campaign slogan is "Play It Straight for Safety's Sake." The society selected it due to the high correlation of accidents associated with drug and alcohol use.

For information on ordering campaign posters, decals, mail stuffers and a free guide for planning a community or company Safety Week campaign, write to ASSE Marketing and Public Relations Department, 1800 E. Oakton St., Des Plaines, IL 60018-2187.
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Author:Truex, Bruce A.
Publication:Risk Management
Date:Apr 1, 1990
Words:1402
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