The Civil Litigator
| Publication year | 1981 |
| Pages | 3103 |
| Citation | Vol. 10 No. 12 Pg. 3103 |
1981, December, Pg. 3103. The Civil Litigator
Knowledge of the impact of tax law on nontax litigation provides a potent tool for the civil litigator. A basic understanding of tax law concepts can be utilized to the advantage of your client at each claim through discovery and pre-trial proceedings, trial, judgment and settlement. The alert litigator who weighs the implications of the tax laws applicable to particular nontax litigation possesses a distinct advantage over his or her adversary and best serves the client by maximizing the net recovery and deductibility of litigation awards.
Basic rules regarding the taxation and deduction of litigation damage payments can be summarized as follows:
1. Damages received for a broadly defined range of personal injuries are not taxable. In other contexts, damages in lieu of income, punitive damages and windfall recoveries are taxable.(fn1)
2. Business injury damages reflecting lost earnings or profits are taxable, but damages for loss of a capital asset such as good will and business reputation are taxable at reduced capital gains rates only on the amount recovered in excess of the basis of the asset.(fn2) Damagepayments are deductible if they are ordinary and necessary business expenses, but are not deductible if payment is for penalties or punitive damages.(fn3)
3. The cash basis taxpayer must include taxable damages in income in the year received. The accrual basis taxpayer must do so in the year of final judgment or settlement.(fn4) A damage payment may be deducted by the cash basis taxpayer when paid and by the accrual basis taxpayer upon final judgment or settlement.(fn5)
These basic tax rules frequently can be applied beneficially in many types and at many stages of nontax litigation, whether complex or the "garden variety."
Tax impacts may arise immediately in the initial stages of nontax litigation. Properly drafted pleadings can increase or preserve the financial gains and minimize the income tax consequences of the litigation.
In marshalling the theories of recovery for inclusion in the complaint or counter-
claim, counsel should consider potential income tax exposure as an element of compensable damages. Traditionally, income tax consequences of damage awards have been excluded as a separate element of damages due to the speculative nature of parties' tax and financial situations.(fn6) However, courts increasingly have awarded substantial amounts to offset increased income taxes in addition to the taxes which would be payable if the amounts recovered in litigation had been received in the normal course of business.
In a recent employment discrimination case, seven plaintiffs won nearly $74,000 for recovery of increased income taxes due to the bunching of plaintiffs' back compensation into one taxable period.(fn7) Likewise, the loss of tax benefits has been allowed as recoverable damages, if such loss was within the reasonable contemplation of the parties.(fn8)
In the complaint or counterclaim, the litigator should plead specifically, as a separate theory of recovery, any possible damages for increased income taxes or loss of tax benefits sustained by the client. Such claims should not be swept into a catch-all request for "other appropriate relief." Despite the simple notice pleading requirements of the Federal and Colorado Rules of Civil Procedure, failure to plead potential income tax losses decreases the possibility of recovery for such damages and exposes the successful litigant to subsequent substantial tax liability. The following two examples illustrate the opportunities and the pitfalls for the litigator at the pleadings stage.
In Durkee v. Commissioner,(fn9) a plaintiff in nontax litigation sought business injury damages due to loss of good will. The complaint alleged that the loss of good will was measured by lost profits (which are normally taxable). However, the complaint did not allege the lost profits as a separate claim for recovery. On the basis of the specific wording of the complaint, plaintiff's recovery was held attributable to the loss of good will, a capital asset (taxable at capital gains rates only in excess of basis), and was not attributed to fully taxable lost profits.
In contrast, in Guild v. Commissioner,(fn10) the failure specifically to plead a claim for income tax damages subjected the plaintiff to massive tax liability. A discharged executive had accepted a block of stock from his corporate employer in settlement of litigation concerning his termination and loss of his corporate stock option. However, the executive was then subjected to an income tax deficiency of over $160,000 on the $253,000 value of the stock received in settlement. The results could have been quite different if...
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