The importance of the tax rules in litigation is often overlooked by the uninitiated. Unlike the well-planned business transaction, the plaintiff’s goal in litigation may simply be to recover money damages. The defendant’s goal may simply be to avoid liability. Consequently, tax planning is frequently overlooked in view of seemingly more pressing aspects of the case.
But when you finally get around to considering tax issues, the opportunity for meaningful planning may already have passed. It’s always best to begin planning for the desired tax treatment of the matter from the inception of the suit—even before the complaint is filed.
From the plaintiff’s perspective: If a particular judgment or settlement is fully taxable at ordinary income rates, that’s the least desirable result. It would be better if the same dollar amount of money damages is taxed at capital gain rates. Of course, the best in an economic sense is if the recovery is entirely tax free!
From the payor or defendant’s perspective: The degree of bitterness associated with the plaintiff’s recovery may vary considerably depending on whether the judgment is paid out entirely on a tax-deductible basis, or if it’s only partially deductible or wholly nondeductible. The defendant may also feel less ire at paying out to a plaintiff when the defendant knows that the amount the plaintiff receives will be taxable as opposed to tax free.
Understanding these opposing perspectives may influence settlement negotiations and/or may even assist the parties in planning a recovery under a judgment to achieve favorable tax treatment.
Keep in mind that it makes no difference to the tax result whether the suit is settled or proceeds to judgment. Estate of J.T. Longino (1959) 32 TC 904. So there shouldn’t be any tax incentive against settling the litigation. In fact, there are generally considerably greater tax planning techniques available when the litigation will be concluded through settlement.
Some litigators think that getting something in the court order on the tax treatment of the recovery or payment will help them get the desired result better than with a settlement. But court orders don’t reign supreme here: a court’s statement may be no more probative as to the actual tax treatment of the item than the recitation of its treatment in a settlement agreement.
In addition, many courts are reluctant to prescribe the tax treatment of an item by virtue of the court’s ostensibly nontax role. Taxpayers sometimes request a judge in a jury trial to specifically address the tax issue via jury instructions. The responses to such jury instructions may constitute some evidence of the tax treatment intended, but certainly would not bind the IRS. Taxpayers may derive some comfort from such a procedure, but ultimately it doesn’t entirely resolve the tax inquiry.
Convinced that understanding tax issues is important for litigators? Get much more on the taxation of various business recoveries in CEB’s California Attorney’s Guide to Damages, chapter 7. For everything you need to know about the taxation of judgments and settlements in employment cases, turn to CEB’s Employment Damages and Remedies, chap 9.
Related CEB blog posts:
- Is the Money You Got in Your Employment Case Taxable?
- The Net, Net Gift That Keeps on Giving (But It’s Risky)
- IRS is Very Strict When It Comes to Charitable Contribution Rules
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