Federal Income Tax Consequences of Settlements and Judgments- Part Ii: Defendants
| Publication year | 1986 |
| Pages | 216 |
| Citation | Vol. 15 No. 2 Pg. 216 |
1986, February, Pg. 216. Federal Income Tax Consequences of Settlements and Judgments- Part II: Defendants
When a defendant must pay to settle a suit or satisfy a judgment in civil litigation, that payment may be deductible for federal income tax purposes. If the payment is deductible and the defendant has sufficient income to benefit from that deduction, the net cost after taxes to the defendant is reduced. Therefore, it is important for the defendant and the defendant's attorney to understand whether the defendant's payments are deductible and, if so, when.
In the January issue at 38, Part I of this two-part article addressed the tax consequences of settlements and judgments from the perspective of the plaintiff. This month, the focus is from the viewpoint of the defendant. To provide the best possible representation for the client, whether plaintiff or defendant, the attorneys should be familiar with the federal income tax consequences for both.
Deductions for federal income tax purposes are a matter of legislative grace.(fn1) Therefore, in order for the defendant to deduct the payment of a settlement or a judgment, a statutory provision must authorize the deduction.
If the liability for the settlement or judgment arose in a business context, the defendant may be able to deduct the payment under the statute which permits a deduction for all ordinary and necessary business expenses.(fn2) In addition to being ordinary and necessary, the expense must be incurred in a trade or business carried on by the taxpayer.(fn3) Also, it must not be a personal expense nor represent a capital expenditure (e.g., payment for an asset whose cost must be capitalized).(fn4)
Under the appropriate circumstances, this statutory provision may be used to deduct damages paid as a result of an automobile accident. In one case, the defendant, a trainer and driver of trotting horses, accidentally struck a child on a bicycle while driving between the farm where he had trained horses that morning and his principal office in his home where he intended to continue conducting business that day.(fn5) The court held that the defendant's payment to settle the suit by the injured child was deductible as an ordinary and necessary business expense because the defendant was traveling "on business" at the time of the accident. The accident occurred during travel which was an integral and necessary part of the defendant's business.
In another case, the corporation which owned the vehicle at fault in the accident was permitted to deduct the damages it paid as an ordinary and necessary business expense.(fn6) The corporation, its two shareholders and their son (the driver) were sued as a result of the accident. The parents allowed the son to drive the corporation's car despite his bad driving record (ten speeding tickets and three accidents in five years, a suspended license in one state and a revoked license in another).
The son had an accident that rendered the plaintiff a quadraplegic. At the time of the accident, the son was not employed by the corporation and was not driving while on its business. However, the corporation's attorney advised that the plaintiff was likely to win at trial based on the theory that the corporation's entrustment of the car to the son was negligent. The corporation was the only defendant with any substantial assets to pay a judgment so the corporation's assets and business were at risk in the suit. The corporation's payment was an ordinary and necessary business expense.
However, damages arising from an automobile accident while commuting (a personal expense for federal income tax purposes) are not deductible. A defendant who accidentally struck a pedestrian while driving from his office to his home was commuting.(fn7) The defendant could not deduct the damages paid because the damages in that case were not directly connected with or proximately resulting from the defendant's trade or business.
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