* Under the origin-of-the-claim test, damages are taxed in the same manner as the item they are intended to replace.
* In many cases, the recipient has no documentation of the origin of the damages or settlement payments and, thus, must allocate a payment between taxable and nontaxable sources.
* In the absence of an express allocation in a final judgment or settlement agreement, courts use a facts-and-circumstances test to determine the proper allocation.
Investors who receive damages from securities litigation must determine how to report them on their tax returns. This article summarizes the relevant rules for characterizing such damages or settlements as ordinary income, capital gain, nontaxable return of capital or fully taxable punitive damages.
The dramatic decline in the value of securities listed on the major stock markets beginning in January 2000 resulted in a flood of lawsuits and arbitration cases by investors. For example, the National Association of Securities Dealers (NASD), the largest securities dispute resolution forum in the world, reported a 56% increase in arbitration cases filed against securities firms and their employees (e.g., stockbrokers) by investors from 1998 to 2002, and a 17% increase in 2003. (1) Investors are using a number of different theories, including unauthorized trading, failure to supervise brokers, placing investors in inappropriate investments, overcharging commissions and misrepresenting investment risks. (2) At the same time, investors are also filing numerous class-action lawsuits against company executives, boards of directors and auditors, accusing them of negligence and fraud.
The NASD securities dispute resolution forum decided 1,658 cases as of November 2003, with 54% resulting in damage awards for the aggrieved investors. (3) The recipients of these and other damage awards must determine whether to report the amounts received as ordinary income, capital gain, non-taxable restorations of capital or fully taxed punitive damages on their returns. Unfortunately, determining the taxation of damage awards requires navigating through a maze of court decisions and IRS rulings. This article summarizes the relevant rules and provides some guidelines for those fortunate enough to recover some or all of their losses.
The U.S. Supreme Court has long held (4) that the origin-of-the-claim test determines the tax consequences of damages received for judgments and settlements. This test taxes damages received in the same manner as the items they are intended to replace. Courts have used this test extensively to tax damages received for lost profits as ordinary income, (5) to treat damages received for harm to capital assets as either a nontaxable return of capital or as capital gain (6) and to hold that damages received for nontaxable items (e.g., gifts or inheritances) are nontaxable. (7)
The origin-of-the-claim test is likely to cause damages received for losses on securities investments to be characterized as ordinary income, capital gain or a nontaxable return of capital. Damages received as a result of lost interest and dividend income on an investment are clearly ordinary income to the recipient. (8) For example, shareholders received ordinary income when a financial adviser reimbursed them for a loss of dividends. (9)
In contrast, damages received for harm to capital assets (e.g., securities investments) are nontaxable to the extent of the plaintiff's basis in the capital asset and are capital gain to the extent they exceed basis. For example, damages received for the fraudulent taking of an investor's stock became a capital gain to the extent it exceeded her stock basis. (10) Likewise, damages received from a settlement of a stockholders' derivative action against a corporation's directors and officers for fraud and mismanagement were nontaxable, because they did not exceed the plaintiff's basis in the worthless stock. (11)
Burden of Proof
To secure the more favorable treatment for harm to capital assets, the recipient has the burden of proof on several items. First, the plaintiff must establish that the origin of the claim is harm to a capital asset; if he or she cannot prove this, the damages are ordinary income for lost profits. Second, the plaintiff must establish the asset's adjusted basis; if he or she does not prove the asset's basis, the entire damage award is taxable. (12)
Third, the plaintiff needs to establish that there has been a sale or exchange of property. Rev. Rul. 74-251 (13) indicates that unless "it can be clearly established that there has been a sale or exchange of property, money received in settlement of litigation is ordinary income." Meeting these requirements should be fairly straightforward for investors--investments are clearly capital assets, basis may be established by the investor's monthly investment account reports and any investment that becomes worthless or is sold will meet the...