Substantiating the Tax Treatment of Settlement Payments

In order to assess the true economic value of a settlement proposal, a plaintiff must consider whether a settlement payment would constitute ordinary income, excludable (non-taxable) income, or proceeds from the disposition of a capital asset.

Non-tax practitioners generally understand that the tax treatment of settlements are determined by the origin of the claim test, see United States v. Gilmore, 372 U.S. 39 (1963), and that if a settlement agreement expressly allocates the settlement payment to a specific claim, the courts generally respect that express allocation, see Threlkeld v. Commissioner, 87 T.C. 1294, 1306-1307 (1986), affd. 848 F.2d 81 (6th Cir. 1988).

In many or most cases, however, the settlement agreement does not contain an express allocation.  Rather, there often is an exhaustive recitation of numerous claims that the plaintiff may or may not have raised along with language releasing the defendant from liability for all of those asserted and unasserted claims in consideration of the settlement payment.  In such cases, application of the origin of the claim test becomes problematic.

A common formulation of the test is to ask the question: What claims did the defendant intend for the plaintiff to forego prosecuting in exchange for the settlement payment?  Strictly speaking, in the case of a settlement agreement releasing claims both raised and not raised by the plaintiff, the defendant intends that the plaintiff forego prosecuting each one of those actual or theoretical claims.  Therefore, literally applying the test would require an allocation of the settlement payment across all of these claims.  Perhaps recognizing this practical problem, some courts have adjusted slightly the test.  “The character of the settlement payment hinges ultimately on the dominant reason of the payor in making the payment.”  (Emphasis added.)  Longoria v. Commissioner, T.C. Memo 2009-162 (2009).

Even with an adjusted version of the test, a plaintiff must establish and the court must determine the defendant’s dominate purpose in making the settlement payment.  The determination is a question of fact.  Bagley v. Commissioner, 105 T.C. 396, 406 (1995), affd. 121 F.3d 393 (8th Cir. 1997).  The court may consider all of the facts that reveal the payor’s intent, such as the circumstances that led to the agreement, the allegations in the complaint, and the amount paid.  Robinson v. Commissioner, 102 T.C. 116, 127 (1994), affd. in part, revd. in part and remanded on another issue 70 F.3d 34 (5th Cir. 1995).  As one might expect, the outcomes in the reported decisions are very factually specific.

The allegations contained in the plaintiff’s complaint are typically the first item of evidence examined.  Thus, in Parkinson v. Commissioner, T.C. Memo 2010-142 (2010), to determine whether settlement payments were paid on account of physical injury and sickness, the United States Tax Court examined the plaintiff’s state court complaint and found that it “did reflect, extensively, his assertions of physical injury and sickness. The complaint alleged that the actions of the medical center and its employees directly caused his second heart attack. Further, the complaint alleged that petitioner’s complete disability and permanent damage to his cardiovascular system resulted directly from his heart attack.”

In Longoria v. Commissioner, T.C. Memo 2009-162 (2009). though, the court looked “to Mr. Longoria’s State court complaint to see whether it states more particular claims (i.e., ‘physical injury or physical sickness’).” The plaintiff’s claims were for “discrimination, retaliation, and civil rights violations; and the damages Mr. Longoria claimed were: loss of income; loss of fringe benefits (including but not limited to medical benefits, dental benefits, and pension benefits); loss of seniority in higher positions; severe mental anguish; anxiety; stomach problems; sleep disorder; stress; diminution of the quality of his life and other hedonistic injury.”  Most of these injuries–loss of income, loss of fringe benefits (including but not limited to medical benefits, dental benefits, and pension benefits), and loss of seniority in higher positions–are non-physical.”  In the context of a settlement agreement, the nature of the claim underlying the plaintiff’s damage award, as viewed by the defendant, rather than the actual validity of the plaintiff’s claim, is determinative.  See United States v. Burke, 504 U.S. 229 (1992).  Thus, in holding against the plaintiff, the court reasoned that “although Mr. Longoria gave credible testimony at trial about other injuries that were plainly physical–e.g., bruised ribs, smoke inhalation, animal bite, and back injury–none of these injuries was alleged in Mr. Longoria’s complaint, and we cannot find that the State of New Jersey agreed to settle because of them.”

Nevertheless, the failure to plead in the complaint the claim to which the plaintiff allocates damages is not always fatal.  In Eisler v. Commissioner, 59 T.C. 634 (1973), the court “did in fact find that a claim not pleaded in the complaint was nonetheless settled by an unallocated settlement agreement, because the claim was brought up between the respective parties’ counsels during settlement negotiation. However, the Court reached that conclusion only because it was “satisfied by the testimony of a former officer of [the defendant in the State court lawsuit], petitioner himself, and counsel for the respective litigants that both the stock claim and the threatened negligence claim had real value in the minds of the litigants . . . when they executed the . . . Release.”

Although few published cases discuss the content of written discovery responses, deposition testimony, and settlement correspondence, all of these would be relevant evidence.

Plaintiffs rarely have had success in allocating post-trial settlements differently than the judgment or verdict, notwithstanding the pendency of an appeal.  “Where there has been a judgment in a trial court that preceded the settlement of the claims, the most persuasive evidence of the payor’s intent in settling the case is the previous award of that court.” Francisco v. United States, 267 F.3d 303, 320 (3rd Cir. 2001); see also Robinson v. Commissioner, 70 F.3d at 38 (the verdict provides “the best indication of the worth of the [taxpayer’s] claims).

For example, in Delaney v. Commissioner, 99 F.3d 20 (1st Cir. 1996), the plaintiff obtained a trial court judgment which included prejudgment interest.  The plaintiff and the defendant reached a post-trial settlement which did not allocate any portion of the settlement payment to interest.  The court nevertheless found that a portion of the settlement payment constituted taxable interest income.  The court of appeals held that the Tax Court reasonably considered, inter alia, the intent of the parties in context. The Tax Court’s approach seems especially apt in these circumstances, where a relevant indicator extrinsic to the settlement documentation suggested that their choice of settlement language may have been driven by tax considerations.  Delaney v. Commissioner, 99 F.3d at 24-25.

The plaintiff in Miller v. Commissioner, T.C. Memo 1993-49 (1993), brought two actions against the defendants. In the first action, the jury “awarded petitioner $450,000 in punitive damages and $500,000 in compensatory damages.”  The parties then settled both actions for a total of $900,000.  The court noted that it was “unable to predict with any certainty whether a similar award would have been made in the second action,” and stated that it declined to “speculate what the $50,000 reduction represents.”  Nevertheless the court allocated the settlement payment pro rata the jury’s verdict in the first action.

The plaintiffs were successful, however, in McShane v. Commissioner, 1987 T.C. Memo 151 (1987).  In that case, the plaintiffs obtained a $ 1,275,000 jury award in a personal injury action under a state-law regime that entitled them to statutory prejudgment interest.  The parties settled during the appeal for an amount greater than the jury award.  In holding that no part of the settlement payment constituted taxable interest, the United States Tax Court scrutinized the details of the settlement discussions and found that at the insistence of the defendant “all of the settlement agreements provided that the lump sums were to be paid ‘without costs and interest.’ During the negotiations the tax consequences of the settlements without interest were never discussed or considered.  The amounts were arrived at by each of the parties taking into consideration their risk or ‘exposure’ by a continuance of the appeal. The total of the settlements was equal to the total of the verdicts in the lower court plus statutory interest to an arbitrarily chosen date less a 5 percent discount.”

Given the evidence that courts have considered persuasive in applying the origin of the claim test to settlement proceeds, attorneys representing plaintiffs should consider how the plaintiff will substantiate the tax treatment of settlement proceeds from the beginning of the case rather than during (or after) the final settlement negotiations.

Michael J. Low is a partner with Janssen Doyle llp.  Mr. Low is a trial lawyer with a practice focused on civil tax controversies, criminal tax investigations, and litigation in state and federal courts involving trusts and estates, accounting, partnerships, executive compensation, and ERISA and non-ERISA plan benefits.  Mr. Low is a graduate of U.C. Berkeley’s Boalt Hall School of Law.


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