Verdict - Fall 2012 - (Page 10)
BY ANSON ASBURY
hether you represent a successful entrepreneur in a business services dispute, an unfairly discharged employee, or the victim of an auto accident, understanding these 10 tax rules may help you reduce your client’s tax burden and enhance your reputation as an experienced litigator and skilled negotiator. If you defend
companies, professionals and insurance carriers, being able to explain the tax consequences of your settlement proposal may turn the tide of negotiation in your favor.
The Timing of an Award Doesn’t Matter, but the Characterization of Damages Does
Whether you settle on the courthouse steps or win a jury verdict, the tax treatment of a litigation award is the same. Even a settlement reached without ﬁling a complaint is subject to the same tax rules. The Internal Revenue Code broadly deﬁ nes gross income, the starting point for federal taxable income. Section 104 of the Internal Revenue Code generally determines the tax treatment of a litigation award by excluding compensation received on account of personal physical injuries or sickness from gross income. However, what qualiﬁes as a personal physical injury is not as straightforward as it might seem. In 1996, Congress restricted the scope of the tax beneﬁt under Section 104 and amended the statute to specify that covered damages must arise from personal physical injuries. Despite the additional language, neither the statute nor the regulations have deﬁned exactly what is meant by a physical injury. The courts have been left to determine the meaning of physical injury and have done so with the breadth of variety that only can be achieved with a series of well-litigated cases. In nearly every instance, however, the taxability of damages has been based upon a judicial doctrine aptly named the “origin of the claim.” The origin of the claim doctrine sprung from a U.S. Supreme Court case that decided the deductibility of attorney’s fees paid in a divorce.1 The primary issue in the divorce was control over the husband’s business. The husband argued that his legal fees were a deductible business expense because he was protecting the source of his income. The court disagreed and held
10 Georgia Trial Lawyers Association
that the origin of his legal claim was personal, i.e. the divorce, and the effect on his business was a collateral consequence of the personal dispute. In the case of a personal physical injury, the origin-of-theclaim doctrine focuses on the nature of the damages. Where the damages are attributable to a personal physical injury or personal sickness the compensation is not taxable. Emotional distress is subject to tax because there is no physical injury. However, pain and suffering can be non-taxable if it is on account of the physical injury. Punitive damages and lost wages are subject to tax because they are not compensation for personal injuries. All of this creates an environment where a smaller total settlement actually can yield more net cash than a larger jury verdict (read on for that scenario).
If There is Any Doubt, Get it in the Settlement Agreement
A settlement agreement will give you the greatest opportunity to shape the tax treatment of the award. The greatest risk is to disregard the tax consequences when drafting a settlement or simply assuming that the tax treatment is established by the complaint. A recent Tax Court decision demonstrated the ﬂaw in that thinking. The taxpayer excluded from income damages received from a litigation settlement. The taxpayer testiﬁed in Tax Court that the settlement arose from “three physical, violent confrontations.”2 However, the settlement agreement described the damages “as arising from events described in the complaint” and the complaint did not seek damages for physical injuries.3 The
Table of Contents for the Digital Edition of Verdict - Fall 2012
In Memoriam: Judge J. Taylor Phillips
10 Tax Tips for Every Litigator
Products Liability, a Primer: Finding the Hidden Defects
Practice Smarter, Not Harder, With These 50 iPad and iPhone Apps
Right and Wronged: Finding Justice for a Whistleblower
Signing a Consent Form for Medical Treatment: What Does it Mean?
The Intersection of Divorce and Your Personal Injury Cases: Tips for Getting the Best Result
Auto Torts Workshop in Photos
Case Updates: What’s New?
Workers’ Comp: Recent Developments
Index to Advertisers/ Advertiser.com
Verdict - Fall 2012