Article

• Publication year: 2014
• Pages: 44
• Citation: Vol. 27 No. 4 Pg. 44

Article Vol. 27 No. 4 Pg. 44 Utah Bar Journal August, 2014

July, 2014.

Big Client Savings Tax-Efficient Settlements

Meagan Carpio and Jason Rogers

Every day lawyers negotiate settlements. Often, the parties are simply happy to get an unfortunate situation behind them and only focus on the dollar amount. Frequently, tax planning is neglected by the parties.

Failing to plan for a desired tax result may result in a tax-inefficient outcome where a client receives less money on an after-tax basis than would otherwise be possible. This article addresses some of the considerations attorneys should keep in mind when drafting settlement agreements.

Settlements vs. Judgments

The Internal Revenue Code applies in the same way to both settlements and judgments. When a dispute is resolved through litigation, often there is little room for tax planning; however, in a settlement situation, attorneys may be able to obtain advantageous tax results for their clients. Since ordinary income can be taxed at a rate up to 39.6%, while long-term capital gains are taxed at no more than 20% for individuals, a favorable agreement can save a client nearly 20% of the settlement amount.

Origin and Nature of Claim Test

For federal income tax purposes, to determine whether a settlement results in ordinary income or capital gain, the origin and nature of the claim test is used. See, e.g., Ash Grove Cement Co. v. United States, No. 11-2546-CM, 2013 WL 451641 (D. Kan. Feb. 6,2013).

For a payee, the test determines:

• whether the settlement amount is excludible from gross income; and

• if the settlement amount is not excludible, whether it is ordinary income or a capital gain.

For a payor, the test determines:

• whether the settlement amount is deductible as trade or business or production of income expense; and

• whether the settlement amount is deductible currently or if it must be capitalized.

Includible or Excludible from Gross Income

For a payee, the first question is whether a settlement payment needs to be included in gross income. Gross income is broadly defined to include nearly every payment. See 26 U.S.C. § 61. Generally, money or property that is received from a settlement is includible in gross income.

However, amounts received from the resolution of physical personal injury claims are excluded from gross income. 26 U.S.C. § 104(a) (2). This is the most favorable treatment of all, so it is in a client's best financial interest...