Remaining tax opportunities in lawsuits and settlements.

• Author: Kerekes, Michael S.

Some of the most appealing tax planning opportunities relating to lawsuits and settlements disappeared when Congress amended Sec. 104(a) in 1996, generally eliminating the exclusion from gross income for compensatory damages received on account of a nonphysical personal injury or sickness and for all punitive damages. (See Tax Clinic, "Taxation of Personal Injury and Sickness Awards," TTA, May 1997, p. 280.) However, there is still a broad range of possible tax results when claims are litigated or negotiated.

Character of Litigation Payments

The character of payments from litigation or claims depends on the nature of the claim giving rise to the payments (Gilmore, 372 US 39 (1963)). This rule applies to both litigation awards and settlement proceeds and affects both payor and payee (Longino Estate, 32 TC 904 (1959)). Claims can be based on rights that would give rise to ordinary income (such as lost wages or business profits), capital gains (such as an asset's purchase or sale) or nontaxable income (such as personal physical injury compensatory damages or certain life insurance proceeds). In addition, in cases involving capital assets, a payment may be treated as a nontaxable return of capital, generally resulting in a reduction of the asset's basis rather than current taxable income (Rev. Rul. 81-277). Under Gilmore's origin-of-the-claim doctrine, the character of legal fees and expenses also follows the nature of the claim.

It is entirely possible for a payment to create an ordinary deduction for the payor without generating ordinary income to the payee. For example, a brokerage business may negligently cause a customer to lose part of the gain that should have been realized on an asset's sale. In this event, the recovery should be characterized as a capital loss to the plaintiff but as an ordinary business expense to the defendant; see, e.g., Letter Ruling 9550011. Such "win-win" characterizations may provide an economic benefit that can help bridge the gap between two sides in a negotiation.

Supporting Allocation of Payments to Desired Categories

Allocation of payments depends on all applicable facts and circumstances. The strongest possible evidence of the facts is an...