Taxing California Elder Abuse Recoveries

• Publication year: 2016
• Author: Robert W. Wood

Taxing California Elder Abuse Recoveries

Robert W. Wood

Robert W. Wood is a tax lawyer with Wood LLP, and the author of numerous tax books including Taxation of Damage Awards & Settlement Payments. This discussion is not intended as legal advice.

The U.S. Department of Health and Human Services and Department of Justice report that each year, up to 5 million older persons are abused, neglected, or exploited.¹ Some studies even suggest that as few as one in 23 cases of elder abuse is reported to authorities.² Legislatures in all 50 states have passed some form of elder abuse prevention laws. The laws vary considerably, but abuse can generally be broken into multiple categories, including:

• Physical Abuse, generally involving the infliction of physical pain or injury on a senior;
• Sexual Abuse, involving non-consensual sexual contact of any kind;
• Neglect, such as by failing to provide food, shelter, health care, or protection for a vulnerable elder;
• Exploitation, involving the illegal taking, misuse, or concealment of funds, property, or assets of a senior for someone else's benefit;
• Emotional Abuse, including the infliction of mental pain, anguish, or distress on an elder person through humiliation, intimidation, or threats; and
• Abandonment, involving the desertion of a vulnerable elder by someone with responsibility for care or custody.³

Litigation based on alleged elder abuse is occurring more frequently.⁴ Due to the panoply of applicable laws, it is not surprising that such suits are brought in many different ways. An elder abuse case may involve appalling physical injuries or even wrongful death. Conversely, it may involve entirely financial transgressions. Of course, a single lawsuit may involve multiple claims, including claims based on financial, physical, and emotional harm. The diversity of possible claims makes it difficult to generalize about the tax consequences of elder abuse claims, and, for these and other reasons, there is relatively little discussion in the literature about those consequences.

Like other litigants, plaintiffs in elder abuse cases might not consider tax issues until the conclusion of the case or until the following January, when Internal Revenue Service ("IRS") Forms 1099 arrive reflecting the payment of amounts awarded in respect of their claims. Some plaintiffs wait even longer, first worrying about taxes as they hover over their Form 1040. Taxes on legal settlements, however, can involve a rude awakening.

Section 104 of the Internal Revenue Code ("IRC") can certainly play a part in determining the taxation of awards in elder abuse cases. That section states that recoveries for personal physical injuries, physical sickness, and emotional distress caused thereby are tax-free. There is no reason to think that elder abuse claims should be viewed as a distinct class of cases for purposes of section 104 analysis. Thus, an award deriving from a purely financial elder abuse claim, not involving any component of physical injury or sickness, would presumably be 100% taxable. On the other hand, an elder abuse claim may result in an award that includes some taxable and some tax-free damages, depending on the facts, the claims made, and the resolution of the case. Unfortunately, therefore, the scope of the section 104 exclusion continues to cause taxpayers, lawyers, and tax preparers considerable trouble. The Tax Court is frequently glutted with section 104 cases.⁵

Section 104 tries to divide the world neatly between the physical and the emotional. The provision excluded from income all recoveries in respect of "personal" injuries until 1996, when Congress added the word "physical."⁶ This was mostly aimed at employment lawsuit recoveries: in the 1980s and 1990s, many litigants in discrimination and wrongful termination cases claimed virtually all of their settlements as emotional distress, a "personal injury" that, until the change in section 104, was tax-free. Since 1996, a recovery must be for physical injuries or physical sickness, or for emotional distress damages that arise out of the physical injuries or physical sickness, to be tax-free.⁷

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In elder abuse cases, if there has been significant physical abuse, there may be a good case to treat many, or even all, of the damages as emanating from the physical abuse. Where that is appropriate, plaintiffs will want to expressly state in the settlement agreement that the damages are paid on account of physical injuries, physical sickness, and emotional distress therefrom. It is appropriate to state also that such damages are excludable from the recipient's income under section 104 of the tax code. (That does not make it true, but saying it expressly does not hurt. In the author's experience, such language can often help in an audit.) And, if the plaintiff is claiming tax-free treatment, expressly asking that the defendant not issue a Form 1099 is a good idea, too (and the settlement agreement should expressly so state), since not issuing that form would be consistent with having a recovery entitled to exclusion under section 104.

Of course, many elder abuse cases are mostly, or exclusively, financial. In these circumstances, the section 104 exclusion is of no help. Damages in purely financial cases are fully taxable, and, in all cases, both punitive damages and interest are taxable.⁸

This article focuses on legal fees in elder abuse cases that are not entirely excluded from the recipient's income for tax purposes.

Attorney Fees on Taxable Recoveries

With recoveries that are wholly or partially taxable, the way attorney fees are deducted can be a problem. In Commissioner v. Banks,⁹ the U.S. Supreme Court held that plaintiffs are generally treated as receiving 100% of their settlements and judgments, even if their lawyers receive the settlement funds, withhold ("net") the contingent fees to which the lawyers are entitled, and pay their clients only the balance.

In 100% tax-free cases, of course, this rule causes no harm. For example, if the plaintiff is entitled to a $1 million settlement, but owes a 40% contingent fee to the lawyer, and the plaintiff is treated as having received only $600,000 tax-free, he (or she) pays zero tax. So does a plaintiff who is treated as having received the $1 million award tax-free and thereafter having paid $400,000 to his or her lawyer. But in taxable cases, where any part of the recovery is taxed, it is a different story: the plaintiff will generally be taxed on his net recovery (as opposed to the entire amount) only if the fees can be deducted above the line (i.e., excluded in their entirety from "income" for purposes of determining an individual's "adjusted gross income").

In 2004, Congress amended IRC section 62(a) (which provides that "adjusted gross income" means, in the case of an individual, gross income minus amounts included in a list of specified deductions) to add section 62(a)(20), allowing an above-the-line deduction for certain legal fees:¹⁰

Any deduction allowable under this chapter for attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination (as defined in subsection (e)) or a claim of a violation of subchapter III of chapter 37 of title 31, United States Code [1] or a claim made under section 1862(b)(3)(A) of the Social Security Act (42 U.S.C. 1395y(b)(3)(A)). . . .¹¹

For cases covered by the amended law—primarily employment cases and whistleblower claims—the change has been huge. The provision...