South Carolina Lawyer
SC Lawyer, January 2010, #2.
Ahlborn, Jackson and the Three Most Important Words in Personal Injury Practice
South Carolina LawyerJanuary 2010Ahlborn, Jackson and the Three Most Important Words in Personal Injury PracticeBy Robert B. Pearlman Within the bounds of memory, the pleading of a personal injury case required the skills of an "artist." Over the years, this art form has often been overridden by the need for hyper-efficiency in practice or eagerness to settle the case. Personal injury counsel now need, more than ever, to be alert to the requirements of intelligent pleading and the ultimate resolution of their cases, always mindful of the three most important words in trial practice: allocation, allocation and allocation.
Counsel "in the know" have long been aware that tax considerations may require well-considered allocations among damage claims. Attempts to make those allocations at or after settlement or judgment will not necessarily suffice. Some attorneys have begun to worry that proper practice considerations place the onus for tax and Medicaid allocations on the trial lawyer and that his or her failure to properly make these necessary allocations can result in malpractice liability. See, e.g., Grillo v. Petiete, 96-145090-92 (96th Dist. Ct., Tarrant Cty., Texas) (settled by attorney and GAL for $4.1 million in damages); Dept. of Soc. Servs. v. Saunders, 724 A.2d 1093 (Conn. 1999); Bd. of Overseers of the Bar v. Brown, 2002 Me. LEXIS 190 (Me. October 25, 2002).
For example, unless treated otherwise by other sections of the Internal Revenue Code, amounts received as either award or settlement of a lawsuit are included in income by Section 61 of the Internal Revenue Code (Code) and taxed accordingly. Section 104(a)(2) of the Code excludes damages, whether by way of court judgments or out-of-court settlements, provided they are received on account of personal physical injury of some sort. It used to be that all damages in the personal injury category were excluded, including punitive damages, (see, Rev. Rule 75-232), but since 1996 that is no longer true. O'Gilvie v. United States, 519 U.S. 79, 117 S. Ct. 452 (1996).
To the extent that IRC Section 104(a)(2) is not applicable, payments received as a result of tort claims are taxable, at least so far as the award or settlement amount exceeds the plaintiff's cost basis. Damages resulting from a tort action not originating in a personal physical injury, such as property damage or interference with property rights, defamation, emotional distress, economic rights, punitive damages, etc., are not entitled to exclusion from income for tax purposes. This means that the gross amount of award or settlement is includible in the client's gross income for tax purposes before any reduction for attorney's fees is allowed. See, e.g., Comm'r v. Banks, 543 U.S. 426, 125 S. Ct. 826 (2005). The plaintiff will, however, be entitled to an offsetting deduction of legal fees under Code Section 62.
The tendency is to plead damages in a general sense, frequently putting forward a laundry list of claims for relief. Because the claims, if successful, will each then involve some combination of amounts constituting ordinary income, capital gains, excluded recoveries or even employment taxes, the problem in addition to "winning" is the proper and best allocation. To do this, the essence and nature of the claims and the purpose of the damage payments must be resolved and clearly laid out.
The courts have developed at least three different, but somewhat similar, tests to make these determinations, examining the origin of the claim litigated and the facts and circumstances of each case. See Woodward v. Comm'r, 397 U.S. 572, 90 S. Ct. 1302 (1970); United_ States v. Gilmore, 372 U.S. 39 (1963); United States v. Patrick, 372 U.S. 53 (1963); Hort v. Comm'r, 313 U.S. 28, 61 S. Ct. 757 (1941); Raytheon Prods. Corp. v. Comm'r, 144 F.2d 110 (1st Cir. 1944); Church v. Comm'r, 80 T.C. 1104, (1983); Delaney v. Comm'r, 99 F.3d 20 (1st Cir. 1996); Fono v. Comm'r, 79 T.C. 680 (1982), aff'd, 749 F.2d 37 (9th Cir. 1984); Threlkeld v. Comm'r, 87 T.C. 1294, (1986), aff'd, 848 F.2d 81 (6th Cir. 1988); Bent v. Comm'r, 87 T.C. 236 (1986), aff'd, 835 F.2d 67 (3rd Cir. 1987); Stocks v. Comm'r, 98 T.C. 1 (1992) (emphasizing the importance of the payor's intent); Metzger v. Comm'r, 88 T.C. 834 (1987...