DESIGNING THE TAX TREATMENT OF LITIGATION-RELATED COSTS.

• Author: Pandya, Sachin S.

1. INTRODUCTION II. BACKGROUND III. ATTRIBUTING LITIGATION-RELATED COSTS TO INCOME-PRODUCING ACTIVITY IV. LIABILITY INSURANCE PROCEEDS V. COORDINATION OF TAX CONSEQUENCES OF DAMAGES PAYMENTS A. The Equal-Amounts-Realized Rule B. The Social Product C. Coordination VI. LITIGATION-RELATED COSTS AS CAPITAL EXPENDITURES VII. DEFAULT RULE: SETTLING DEFENDANT PROMISES NOT TO SEEK DEDUCTION VIII. CONCLUSION I. INTRODUCTION

   Defendants can often deduct from income tax their litigation-related costs, such as attorney fees and payments to settle claims or satisfy judgments. This remains controversial. Consider for example the billion-dollar settlements by some financial institutions for their role in the 2008 financial crisis. Some have pointed out that despite the high nominal settlement price, those financial institutions really paid a much lower after-tax settlement price. (1) Or consider that while British Petroleum agreed to a $20 billion settlement of claims arising from the Deepwater Horizon oil spill, by one estimate, $15.3 billion of that amount was tax-deductible. (2) A more recent example: When U.S. President Donald Trump recently settled lawsuits alleging fraud in his former "Trump University" business, Trump agreed to pay $25 million in restitution. Neither Trump, nor the private plaintiffs, nor the New York Attorney General mentioned that because most of this $25 million was tax-deductible, Trump's after-tax settlement price was a lot less. (3)

   Similarly, when defendants settle with government agencies, there is this worry: Both defendants and government regulators highlight the settlement sticker price, not the much lower after-tax settlement price; as a result, settling defendants inflate their contrition, regulators inflate their law-enforcement zeal, and both thereby mislead the public. (4) Such concerns also fuel the long-standing controversy over the tax deductibility of punitive damages awards. (5)

   These controversies, however, depend on your answer to this harder question: How should income tax law treat litigation-related costs? On this question, prior commentary offers two main answers. Some oppose deductibility, fearing that it reduces how well monetary sanctions can enhance social welfare or proportionally match a defendant's moral responsibility for illegal activity. (6) For every dollar a defendant avoids in tax liability by deducting damages, the civil justice system becomes that much less effective in meeting its goals in that defendant's case. For this reason, the tax treatment of litigation-related costs matters to the purposes, scope, and effect of the entire civil justice system.

   Others, however, favor deductibility so that personal income tax burdens can more closely depend on net personal income (one's gross receipts minus one's cost of producing those receipts). If so, their argument goes, income tax law would tend not to affect what a taxpayer does to produce income and would also make personal income tax burdens roughly proportional to taxpayers' actual buying power. (7) This implies that an income tax code should calibrate tax burdens by accounting for all the costs of receipts-producing activity, including litigation-related costs, even if such activity is illegal or socially disfavored. (8)

   The problem is that despite the high stakes for the entire civil justice system, prior commentary on this question has largely ignored some critical tax-design issues. (9) Put simply, taxing only net income does not entail allowing deduction of all litigation-related costs. How should we structure litigation-cost deductibility? It depends on a series of complex and interconnected tax-design choices, such as how to attribute income to taxpayer activity; how to treat liability insurance payments; whether to coordinate the tax consequences of defendant-payors and plaintiff-payees; and how much tax authorities and taxpayers should be expected to do to enforce or comply with income tax law, respectively. These design choices are distinct. They do not necessarily follow from any specific redistributive goals for the tax system or from corrective justice or social-welfare-maximization goals for imposing monetary legal sanctions. And yet, for progress and clarity to occur, lawyers, judges, and scholars must no longer ignore these issues.

   This Article identifies these tax-design choices. The Article proceeds as follows. Part II briefly surveys the relevant tax law in seven countries, focusing on the relevant U.S. tax law. The Article then turns to the key tax-design issues. Part III discusses the complexity associated with attributing litigation-related costs to an income-producing activity. Part IV discusses whether to treat liability insurer payments made on a defendant's behalf as income to that defendant. Part V identifies grounds for coordinating the tax treatment of a defendant-payor's damages payments with the tax treatment of those receipts to the plaintiff-payee, namely, that these payments are part of bilateral exchanges in which the defendant pays the plaintiff for a loss or for the value of property the defendant still has and uses. Part VI concerns whether some litigation-related costs should be treated as capital expenditures related to the right to receipts established or sought to be established by the litigation itself.

   Finally, Part VII proposes a new default rule for settlement agreements: Unless expressly indicated otherwise by agreement or statute, a settling defendant promises, as a term of the settlement, not to seek an otherwise allowable tax deduction for litigation-related costs. Under current U.S. law, parties can already enforce such a settlement term, and a few have done so. By adopting such a term as a default rule, lawyers for private parties and the government would be more accountable in their settlements. If settlement agreements contain an express term allowing a party to seek a tax deduction for litigation-related costs, such agreements would credibly signal to judges and the public that the settling parties were aware of the gap between the nominal and the after-tax settlement price, and settled anyway. Accordingly, policymakers would be forced to grapple with whether and how to abrogate that default rule when they enact or amend causes of action.

   This Article substantially advances the prior commentary (which is largely descriptive or outdated) (10) in several ways. It both extends and takes issue with prior work on whether to treat liability insurer payments made on a defendant's behalf as income to that defendant. (11) It examines and complicates the grounds for prior arguments that litigation-related costs should be treated as capital expenditures. Finally, the Article offers a novel default rule that would make policymakers more likely to fully and openly grapple with the tax-design choices identified here.

2. BACKGROUND

   In at least seven jurisdictions (United States, Canada, France, South Africa, Australia, Germany, United Kingdom), income tax law, at least on paper, generally permits deductions for payments for attorney fees and payments to settle or satisfy claims, provided such payments are sufficiently connected to income-producing activity, particularly trade or business activity. (12) Taxpayers generally cannot deduct fines and penalties payable to the government, either because of an express statutory prohibition (e.g., United States, Canada, France, South Africa, Australia) or a general judicial and agency authority to disallow deductions on a case-by-case basis (e.g., Germany, United Kingdom). (13) Moreover, some taxpayers pay litigation-related costs to acquire, dispose of, or defend title to an asset, such as a parcel of land, a patent, or a professional license. (14) If so, they cannot deduct such costs when paid or incurred (as is permitted for an ordinary expense). Instead, those costs must be added to the asset's "basis," or in a non-U.S. jurisdiction, to the asset's tax book value. Then, when one sells or otherwise disposes of the asset, that basis is subtracted from the proceeds, resulting in either a net gain or a loss.

   In the United States, since at least the Revenue Act of 1913, (15) U.S. courts and the government have largely considered attorney fees and other expenses paid or incurred to defend against a lawsuit as "ordinary and necessary" business expenses. Today, Code section 162(a) provides that a taxpayer may deduct "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." (16) As read by courts and government tax officials, section 162(a) and its statutory antecedents treat as "ordinary and necessary" what a taxpayer pays or incurs to settle a claim or satisfy a judgment--including portions of a judgment awarding punitive damages to private parties, (17) as well as attorney fees paid or incurred to defend against a lawsuit--provided that such expenses were paid or incurred "in carrying on any trade or business." When a taxpayer pays to cover another's expenses, however, those expenses do not usually count as that taxpayer's "ordinary" expenses under section 162(a) on the premise that businesses do not customarily pay off the debts of others. (18)

   In 1942, Congress added the predecessor to Code section 212, which allows an individual to deduct "all the ordinary and necessary expenses paid or incurred during the taxable year" for producing or collecting income, including managing, conserving, or maintaining property "held for the production of income," as well as expenses "in connection with the determination, collection, or refund of any tax." (19) To deduct litigation-related costs under section 212, those costs have to be attributed to a legal claim that arose in connection with the individual taxpayer's profit-seeking activity. (20)

   In 1969, Congress amended Code section 162 to expressly disallow some kinds of expenses otherwise deductible under section...