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Taxation of damages from securities lawsuits.

EXECUTIVE SUMMARY

* Under the origin-of-the-claim test, damages are taxed in the same manner as the item they are intended to replace.

* In many cases, the recipient has no documentation of the origin of the damages or settlement payments and, thus, must allocate a payment between taxable and nontaxable sources.

* In the absence of an express allocation in a final judgment or settlement agreement, courts use a facts-and-circumstances test to determine the proper allocation.

**********

Investors who receive damages from securities litigation must determine how to report them on their tax returns. This article summarizes the relevant rules for characterizing such damages or settlements as ordinary income, capital gain, nontaxable return of capital or fully taxable punitive damages.

The dramatic decline in the value of securities listed on the major stock markets beginning in January 2000 resulted in a flood of lawsuits and arbitration cases by investors. For example, the National Association of Securities Dealers (NASD), the largest securities dispute resolution forum in the world, reported a 56% increase in arbitration cases filed against securities firms and their employees (e.g., stockbrokers) by investors from 1998 to 2002, and a 17% increase in 2003. (1) Investors are using a number of different theories, including unauthorized trading, failure to supervise brokers, placing investors in inappropriate investments, overcharging commissions and misrepresenting investment risks. (2) At the same time, investors are also filing numerous class-action lawsuits against company executives, boards of directors and auditors, accusing them of negligence and fraud.

The NASD securities dispute resolution forum decided 1,658 cases as of November 2003, with 54% resulting in damage awards for the aggrieved investors. (3) The recipients of these and other damage awards must determine whether to report the amounts received as ordinary income, capital gain, non-taxable restorations of capital or fully taxed punitive damages on their returns. Unfortunately, determining the taxation of damage awards requires navigating through a maze of court decisions and IRS rulings. This article summarizes the relevant rules and provides some guidelines for those fortunate enough to recover some or all of their losses.

Overview

Origin-of-the-Claim Test

The U.S. Supreme Court has long held (4) that the origin-of-the-claim test determines the tax consequences of damages received for judgments and settlements. This test taxes damages received in the same manner as the items they are intended to replace. Courts have used this test extensively to tax damages received for lost profits as ordinary income, (5) to treat damages received for harm to capital assets as either a nontaxable return of capital or as capital gain (6) and to hold that damages received for nontaxable items (e.g., gifts or inheritances) are nontaxable. (7)

The origin-of-the-claim test is likely to cause damages received for losses on securities investments to be characterized as ordinary income, capital gain or a nontaxable return of capital. Damages received as a result of lost interest and dividend income on an investment are clearly ordinary income to the recipient. (8) For example, shareholders received ordinary income when a financial adviser reimbursed them for a loss of dividends. (9)

In contrast, damages received for harm to capital assets (e.g., securities investments) are nontaxable to the extent of the plaintiff's basis in the capital asset and are capital gain to the extent they exceed basis. For example, damages received for the fraudulent taking of an investor's stock became a capital gain to the extent it exceeded her stock basis. (10) Likewise, damages received from a settlement of a stockholders' derivative action against a corporation's directors and officers for fraud and mismanagement were nontaxable, because they did not exceed the plaintiff's basis in the worthless stock. (11)

Burden of Proof

To secure the more favorable treatment for harm to capital assets, the recipient has the burden of proof on several items. First, the plaintiff must establish that the origin of the claim is harm to a capital asset; if he or she cannot prove this, the damages are ordinary income for lost profits. Second, the plaintiff must establish the asset's adjusted basis; if he or she does not prove the asset's basis, the entire damage award is taxable. (12)

Third, the plaintiff needs to establish that there has been a sale or exchange of property. Rev. Rul. 74-251 (13) indicates that unless "it can be clearly established that there has been a sale or exchange of property, money received in settlement of litigation is ordinary income." Meeting these requirements should be fairly straightforward for investors--investments are clearly capital assets, basis may be established by the investor's monthly investment account reports and any investment that becomes worthless or is sold will meet the sale or exchange requirement.

Exceptions to the Origin-of-the-Claim Test

The Code and courts provide limited exceptions to the origin-of-the claim test; most notable are for punitive damages and damages received as a result of physical personal injuries. Punitive damages are taxable to the recipient, even if the origin of the claim is a nontaxable item. (14) The only instance in which punitive damages are not taxable does not apply to securities litigation. (15) Thus, punitive damages received in a securities-related lawsuit are ordinary income to the recipient.

Damages received on account of personal physical injuries or physical sickness are not taxable to the recipient under Sec. 104(a)(2), even if received for a taxable item, such as lost income. This rule is also unlikely to come into play in a securities-related lawsuit, although occasionally a plaintiff may attempt to use this provision. For example, an investor may claim that the emotional distress caused by the securities' losses led to a bleeding ulcer, heart attack or other physical illness. It is highly unlikely that investors would be successful with tiffs approach, however, because most plaintiffs in other types of litigation, such as employment discrimination (e.g., age, race or sex discrimination), are not successful with this approach. The Conference Report (16) to Sec. 104 specifies that damages paid for emotional distress are not excludible if the claim originates as a nonphysical injury (e.g., employment discrimination or securities litigation), even if the emotional distress leads to physical symptoms. However, Sec. 104(a) does allow plaintiffs to exclude damages if received for medical care attributable to emotional distress. Thus, investors could exclude the portion of the damage award that reimburses them for medical expenses connected to emotional distress caused by investment losses.

Allocation of Damage Awards

The tax treatment of damages received from securities investment disputes is fairly clear if the taxpayer can identify the nature of the damages being received (e.g., lost income, return of capital, capital gain or punitive). However, it is not always apparent the types of damages being paid in these disputes, leaving the recipient in the uncertain position of allocating the award between taxable and nontaxable sources. A prime example is damages paid in disputes between investors and their stockbroker or brokerage company. These disputes are typically handled through binding arbitration; defendants in these cases frequently pay damages without admitting wrongdoing. (17) As a result, the recipients are often left without any documentation as to the nature of the damages and may not be able to substantiate their subsequent tax treatment if challenged by the IRS.

Settlement Agreements

The best-case scenario for substantiating the recipient's tax treatment (allocation) of damages is when there exists a final judgment (by a court or arbitration panel) or settlement agreement that clearly indicates what the damages are for. As a general rule, courts hold that the allocations contained in a settlement agreement are binding for tax purposes. (18) Thus, plaintiffs may have an incentive to settle investment-related disputes in an attempt to dictate the damage award's tax treatment. For example, clearly it is in the taxpayer's best interest to indicate that damage payments are a nontaxable return of capital or for appreciation of the investment (taxed as a capital gain), as opposed to lost income or punitive damages (taxed as ordinary income).

Taxpayers and advisers need to exercise caution when negotiating settlement agreements, however, because the IRS is not required to accept settlement-agreement allocations. Even courts are not bound by the agreement's tax language. An allocation in a settlement agreement has a much better chance of being upheld on review if it is negotiated in good faith and at arm's length; (19) the IRS and the courts are much less likely to recognize settlement agreement allocations if the recipient has complete discretion over how the damage payments are allocated. (20)

In addition, a settlement agreement is less likely to be upheld if it is inconsistent with the original complaint or a prior judgment settled while being appealed. For example, if a complaint sought lost profits and punitive damages or a trial court judgment indicates the damages are for lost profits and/or punitive damages, the investor will be hard-pressed to recharacterize the damages as entirely nontaxable in a subsequent settlement agreement. In these cases, it may be more realistic for an investor to characterize at least a portion of the damages received in the settlement agreement as lost profits or punitive damages, while documenting the reasons why a larger portion of the damage award should be allocated to a nontaxable or capital-gain source.

Facts-and-circumstances test: In the absence of express language in a final judgment or settlement agreement regarding the damage allocation, courts use a facts-and-circumstances test to determine how the damages should be allocated. (21) Various circuit courts and the Tax Court have indicated that the recipient's tax treatment in these situations depends on the defendant's intent in making the payment. Was the defendant reimbursing the investor for lost income or for capital invested? The defendant's intent is determined by looking at all of the details surrounding the disagreement, the complaint and all of the parties' arguments in the underlying proceedings. In these situations, the complaint is considered the most persuasive evidence in the subsequent allocation of the damage award. (22)

Need for documentation: Investors seeking to minimize taxes on damage awards need to consider the tax consequences from the beginning of the controversy. It is important for the investor to properly document at each stage of the dispute the types of damages being sought. Courts have held (23) that if there is no allocation in a settlement agreement between the taxpayer's taxable claims (e.g., lost income or punitive damages) and nontaxable claims (e.g., return of capital), and no other evidence of the defendant's intent in making the payment is present, all of the settlement proceeds are taxable. If the plaintiff wishes to minimize the taxes due on any future damages, the complaint and all subsequent paperwork should emphasize that the damages are primarily being sought for lost capital, which is nontaxable unless it exceeds the investor's adjusted basis. On the other hand, the plaintiff must balance minimizing the taxes paid on damage awards against maximizing the actual payout from the defendant. Maximizing the payout may require pursuing a number of different legal theories that may pro vide less tax advantageous payouts, such as punitive damages.

Pervasive uncertainty: Even if taxpayers are vigilant in documenting the future allocation of their damage awards, there are still likely to be situations that present challenges. For example, investors received a recovery from the Dreyfus Aggressive Growth Fund (24) for alleged trading improprieties by the fund manager, and the recipient's tax treatment was not entirely clear. According to the original complaint, the fund manager "used class members' money and the assets of the funds to invest in illiquid stocks in which (the fund manager) had large personal positions." (25) In other words, the fund manager was allegedly "front running" or making purchases in his personal account just ahead of comparatively large purchases by the mutual fund. The complaint also contended that the resulting decline in the fund's value might have been prevented had Dreyfus not attempted to conceal the broker's actions. Dreyfus settled the case without admitting wrongdoing and investors were sent a check with a note stating that the "tax treatment of distributions from the Net Federal and State Settlement Amount is the responsibility of each recipient." The fund company issued no Forms 1099 for these distributions; neither the fund company nor the attorneys handling the case provided additional tax guidance.

Without an allocation of the damages by a final judgment or settlement agreement, the recipients of such damage awards should use the facts-and-circumstances test to determine the taxation of the damages received. The test requires recipients to attempt to discern the defendant's intent in making the payment by examining a number of sources, such as the original complaint, the legal arguments advanced during litigation and other paperwork from the dispute. Usually, the most relevant publicly available source is the original complaint, which details the various allegations.

In the Dreyfus case, for example, the allegations in the complaint involved either the purchase by the fund manager of inappropriate investments or Dreyfus's lack of diligent oversight of the fund manager's actions. The complaint asked only for compensatory damages related to a loss in the fund's net asset value and nonmonetary "injunctive relief to clean up the trading and disclosure policies of the Dreyfus Funds." However, the complaint did not mention punitive damages.

In such a case, diligent tax advisers for recipients need to examine the complaint and any other legal documents available before determining how to report the damages. The correct treatment of the damages is far from certain, but a strong argument can be made that the Dreyfus damages should be treated as a nontaxable return of capital to the extent of each investor's basis. However, different recipients will sometimes take different approaches on how to report such items on their returns; some recipients are more aggressive than others.

Pension Plan Damages

The above discussion on the tax treatment of damage awards from securities-related disputes also applies to investors receiving damages for losses in their personal retirement accounts. Many of the investors bringing actions against securities firms are attempting to recoup losses in their retirement accounts or pension plans. In these situations, the tax treatment of the damage award depends on whether it is paid to the pension fund or directly to the investor. If paid into the investor's pension plan or retirement account, the damages should not be taxable to the investor. (26) In contrast, if damages are paid directly to the investor, they may be taxable, unless the investor rolls the payment over into another qualified pension plan or IRA within 60 days under Sec. 402(c). If the investor does not roll the damages over into a pension or IRA within that time, he or she is in the same position as if he or she took a pension plan distribution (which is likely to lead to a portion of the damages being taxable).

Unreimbursed Investment Losses

Investors unable to secure damages for investment losses will have to settle for tax deductions. While the loss on an investment clearly qualifies as capital, the value of the deduction is severely restricted by the $3,000 limit that applies to net capital losses. (27) Consequently, some taxpayers may attempt to characterize their investment losses as theft (i.e., casualty) losses to fully deduct them against other income. (28) This characterization is usually difficult, because the theft loss rules require taxpayers to show that the taking of property was done with criminal intent and illegal under the laws of the state or jurisdiction where it took place. (29) For example, investors in a limited partnership did not meet the requirements, even though the organizers were sentenced to prison, because one organizer's plea of nolo contendere did not prove that a theft occurred under state law. (30) Theft loss deductions based on the actions of stockbrokers may also be difficult, due to the need to show that the broker acted with criminal intent. (31) However, investors in clearly fraudulent schemes (such as "Ponzi" schemes), are entitled to a theft deduction. (32)

Taxpayers attempting to deduct investment losses as theft losses based on corporate actions have largely been unsuccessful in court. For example, a number of cases (33) have held that the decrease in the value of stock as a result of fraud committed by corporate officers does not result in a theft loss to the shareholder. Likewise, the courts have also held (34) that the theft of corporate property entitles the corporation, but not its shareholders, to a theft-loss deduction. Thus, taxpayers with these types of investment losses are most likely limited to a capital loss deduction.

Conclusion

The rules on the tax treatment of damage awards in investment-related disputes are fairly straightforward. Amounts paid to an investor for lost income are taxed as ordinary income, those paid for lost capital are nontaxable unless they exceed the investor's adjusted basis (resulting in a capital gain) and punitive damages are taxed as ordinary income. The difficulties lie in how damage awards are allocated between these sources by the recipient. Regrettably, many of these disputes generate a settlement that does not specify the nature of the damages being paid. Properly substantiating the allocation of damages can dramatically improve an investor's subsequent tax treatment; this requires investors to consider the tax consequences of the damage payments froth the start of the dispute.

(1) Through November 2003; see the NASD website, at www.nasdadr.com/statistics.asp. Various publications have also documented a surge in lawsuits and arbitration cases by investors over this time; see Morgenson, "An Iceberg of Irate Investors," The New York Times (2/9/03), Section 3. p. 1; Fledman, "Sue Your Broker," 30 Money 10 (October 2001), p. 102; McCafferty, "Now Everyone's a Target," 18 CFO Magazine 8 (August 2002), p. 20.

(2) Statistics on the frequency of each of these types of disputes in NASD arbitration cases are provided at www.nasdadr.com/statistics.asp.

(3) Id.

(4) The origin-of-the-claim test has its origins in Walter Hort, 313 US 28 (1941), and is also articulated in Don Gilmore, 372 US 39 (1963).

(5) See, e.g., Swastika Oil & Gas Co., 123 F2d 382 (6th Cir. 1941).

(6) See, e.g., Raytheon Production Corp., 144 F2d 110 (1st Cir. 1944).

(7) See. e.g., M. Bennett Marcus, TC Memo 1996-190 (lost inheritance); Arthur Donn Vincent, TC Memo 1992-21 (lost gift).

(8) However. after the Jobs and Growth Tax Relief Reconciliation Act of 2003, most dividends are taxed at a rate equal to or less than capital gains; see Hegt, "JGTRRA Cuts Rates, Increases Some Deductions and Credits." 34 The Tax Adviser 542 (September 2003).

(9) Western Products Co., 28 TC 1196 (1957).

(10) Margey K. Megargel, 3 TC 238 (1944).

(11) Louis Boehm, 146 F2d 553 (2d Cir. 1945), aff'd, 326 US 287 (1945).

(12) Raytheon Production Corp., note 6 supra.

(13) Rev. Rul. 74-251, 1974-1 CB 234.

(14) Kevin M. O'Gilve, 519 US 79 (1996), and the Small Business Jobs Protection Act of 1996 amendments to Sec. 104 make it clear that punitive damages are taxable to the recipient, even if they are received on account of personal physical injuries or physical sickness.

(15) Punitive damages are excludible under Sec. 104(c), if awarded under a state wrongful-death statute and such damages are the only remedy available under the statute.

(16) The Conference Committee Report for the Sec. 104 amendment contains a footnote stating that emotional distress claims are not excludible under Sec. 104(a)(2), even if the emotional distress leads to physical symptoms (e.g., insomnia, headaches, stomach disorders); see amended H Rep't No. 104-736, 104th Cong. 2d Sess. (1996), p. 1589.

(17) Brokerage customers sign agreements that prevent them from suing their brokers in court. The majority of these agreements require investors to use the NASD dispute resolution office to arbitrate their dispute.

(18) Hughes A. Bagley, 105 TC 396 (1995), aff'd, 121 F3d 393 (8th Cir. 1996); Bill E. McKay, 102 TC 468 (1994).

(19) James E. Threlkeld, 87 TC 1294 (1986), aff'd, 848 F2d 81 (6th Cir. 1988); Laszio Fono, 79 TC 680 (1982), aff'd, 749 F2d 37 (9th Cir. 1984).

(20) See Edward E. Robinson, 102 TC 116 (1994), aff'd, 70 F3d 34 (5th (Cir. 1995), cert. den.

(21) See Nathan Agar, 290 F2d 283 (2d Cir. 1961), and Eleanor Stocks, 98 TC 1 (1992).

(22) Rev. Rul. 85-98, 1985-2 CB 51.

(23) Romoner J. Strong, Jr., 79 F3d 1154 (9th Cir. 1996).

(24) See "Dreyfus Will Pay $20.5 Million to Settle Lawsuit," The New York Times (6/22/01), Section C. p. 4.

(25) For a copy of the original complaint, contact the authors at hansonr@uncw.edu.

(26) In IRS Letter Ruling 9234016 (5/22/92), embezzled funds restored to the taxpayer's IRA were not taxable income, but part of the IRA's assets.

(27) Sec. 1211(b)(1) limits the deduction of capital losses to $3,000 after they have been netted against capital gains.

(28) The $100 limit under Sec. 165(h)(1) and the 10%-of-adjusted-gross-income limit under Sec. 165(h)(2) only apply to personal-use property; any transaction entered into for profit (e.g., an investment) is exempt under Sec. 165(h)(3)(B) and, thus, is fully deductible against other income.

(29) See Rev. Rul. 72-112, 1972-1 CB 60.

(30) John Hartwick, TC Memo 1988-424.

(31) See, e.g., Lombard Bros. Inc., 893 F2d 520 (2d Cir. 1990).

(32) See, e.g., IRS Letter Ruling (CCA) 200305028 1/13/03).

(33) See, e.g., Ronald De Fusco, TC Memo 1979-230; Herbert Barry, TC Memo 1978-215; and Lester Paine, 63 TC 736 (1975), aff'd, 523 F2d 1053 (5th Cir. 1975).

(34) Drew Jensen, TC Memo 1979-379; First National Bank of Palm Beach, DC FL, 6/22/76.

LeAnn Luna, Ph.D.

Assistant Professor of Accounting

Cameron School of Business

University of North Carolina-Wilmington

Wilmington, NC

James K. Smith, Ph.D., J.D., CPA

Associate Professor of Accounting

University of San Diego

San Diego, CA

Randall K. Hanson, J.D.

Professor of Business Law

Cameron School of Business

University of North Carolina-Wilmington

Wilmington, NC

For more information about this article, contact Prof. Hanson at hansonr@uncw.edu.
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Author:Hanson, Randall K.
Publication:The Tax Adviser
Date:Apr 1, 2004
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