TLD's General Counsel Blog

What Are the Tax Consequences of a Settlement to the Recipient of a Non-Personal Injury Action?

In litigation, any settlements should take into consideration the tax consequences to the client recipient of settlement proceeds. As a litigator, this is something very important to consider for the benefit of the client because the settlement can put the client in a tax bracket over and above what he/she is at, thereby increasing the percentage of tax the client has to pay. Here are the nuts and bolts of the taxability of non-personal injury settlements: all damages/settlements received are taxable as gross income with the exception of damages for emotional distress that are used specifically to pay medical expenses. This article does not address the taxability of personal injury settlements which is treated differently under the Internal Revenue Code ("IRC").

Lost Earnings and Lost Wages

Compensatory Damages received in non-personal injury lawsuits whether pursuant to judgment or settlement are taxable as ordinary income if they compensate the recipient for lost earnings. Estate of Carter v. Commissioner (8^th Cir.1962) 298 F.2d 192. Recoveries in employment contract disputes are generally characterized as ordinary income, just as the compensation would have been characterized under the contract. Stocks v. Commissioner (1992) 98 T.C. 1; Byrne v. Commissioner (1988) 90 T.C. 1000; Glynn v. Commissioner (1981) 76 T.C. 116. Since back pay is a quintessentially contractual measure of damages, any recovery of back wages is taxable, even if paid along with tort-like injuries. Commissioner v. Schleier (1995) 515 U.S.323; United States v. Burke (1992) 504 U.S. 299.

Reimbursement of Legal Fees and Deduction of Legal Fees

Judgment or settlement amounts intended to reimburse a taxpayer for legal fees in non-personal injury cases are generally considered income to the taxpayer. Baylin v.United States (Fed. Cir. 1995) 43 F.3d 1451; Bagley v. Commissioner (1995) 105 T.C. 396; Estate of Gadlow v. Commissioner (1968) 50 T.C. 975; Rev. Rul. 60-14, 1960-1 C.B. 16. Where an attorney is paid under a contingent fee arrangement, the client must include in gross income as a contingent fee. Commissioner v. Bank (S.Ct. Jan. 24, 2005) NO. 03-892 . Under the anticipatory assignment of income doctrine, a taxpayer may not avoid taxation by assigning income to another party. Id.

Legal fees may be deducted as ordinary and necessary business expenses. Whether litigation expenses are deductible business expenses depends on the origin and character of the claim for which the expense incurred and whether the claim bears a sufficient nexus to the taxpayer’s business. US v. Gilmore (1963) 372 US 39. Ordinary and necessary litigation costs generally are deductible when the matter giving rise to the costs is proximately related to a business activity. Woodward v. Commissioner (1970) 397U.S. 572. If indeed the legal fees are qualified as business expense, the effectiveness of the deduction may be substantially limited by the 2 percent floor on miscellaneous itemized deductions under IRC §67 and the alternative minimum tax, under which miscellaneous itemized deductions are completely disallowed.

Emotional Distress Damages in Employment Discrimination/Wrongful Termination Case

Only damages that result from personal injury actions are excluded from gross income. IRC Section 104(a)(2). The exclusion from gross income does not apply to damages received through employment discrimination or defamation actions accompanied by a claim for emotional distress. However, taxpayers can exclude damages received for medical expenses associated with emotional illness (this does not include amounts compensating for emotional distress beyond the medical expenses). IRC § 104(a); Treas. Reg. 1.213-1(g).

Punitive Damages

IRC §104(a)(2) expressly provides that punitive damages are not excluded from income, even though such damages may accompany the award of other damages that are excluded from income.

Article Submitted By: Attorney Pamela Tahim

Employers Required to Provide Same Sex Spouses Same Benefits It Offers Opposite Sex Couples

In a landmark decision, the California Supreme Court recently granted same-sex couples the right to marry, In re Marriage Cases, No. S147999 ( Cal. May 5, 2008). In addition to the right to marry, the Court’s decision grants equal treatment under the law to married same-sex couples and married opposite-sex couples.

 

The most immediate impact on employers is that same-sex couples must have access to many employment benefits that have traditionally been given to married heterosexual couples. The decision went into effect on June 14, 2008.

The California Supreme Court in In re Marriage Cases did not invalidate the domestic partner law, but instead extended the rights and responsibilities granted to married heterosexual couples under California law to married gay and lesbian couples.

Therefore, an employer must now provide same-sex spouses with any benefits that the employer provides to opposite-sex spouses under state law or employer policy.

Examples of state law employment policies that must now extend to same-sex spouses are leaves to care for a spouse and any coverage provided by an insurance policy an employer purchases in California. Examples of possible employer policies that must now extend to same-sex spouses are leaves of absence offered beyond those provided under state law and paying for travel for spouses of employees. An employer who fails to provide spousal benefits to same-sex spouses may be exposed to claims of sexual orientation discrimination under California’s Fair Employment and Housing Act.

Although the In re Marriage Cases decision permits same-sex marriage in California, and grants state law rights to same-sex couples, tension remains between that ruling and applicable federal law. Under the Defense of Marriage Act (DOMA), enacted in 1996, a California same-sex spouse does not qualify as a spouse under federal law. Therefore, benefits covered by federal law, such as ERISA retirement plans subject to the Internal Revenue Code, will not automatically apply to a same-sex spouse. However, the DOMA does not prevent an employer from voluntarily extending coverage to same-sex spouses.

Employers should take active steps to ensure that their policies are in compliance with state law regarding same-sex marriage:

1. First survey all employment policies and benefits provided under state law or employer policy to determine if they provide rights or benefits to an employee’s spouse. If so, the employer should ensure that those benefits are also provided to same-sex spouses or domestic partners.

2. You should also carefully review federally-regulated benefits, such as ERISA benefit plans, in order to determine to what extent the employer should extend those benefits to same-sex spouses or domestic partners.

Reproduced with the permission of the Author, HR Network www.hrnetworkinc.com

Tredway, Lumsdaine & Doyle, LLP., has a team of attorneys ready to help you with your employment matters. For more information on how we can be of service to your company, or about our General Counsel Plan, contact Shannon M. Jenkins or Annie B. Markarian at 562-901-3050.

Article Submitted By: Annie Markarian

Beware of the Contractual Arbitration Clause

Many contracts include mandatory or optional arbitration clauses which either bind the parties of the contract to an arbitration process or give the parties the option of attending an arbitration in the event of a dispute. However, not all arbitration clauses are created equally and all should be carefully reviewed and screened. Easily overlooked provisions such as whether the arbitration is binding or non-binding, a required venue or location in which the arbitration is to take place, the number of arbitrators, and what rules will govern the arbitration proceeding, will all dramatically effect the cost of an arbitration. For instance, a requirement that the arbitration take place at or under the rules of the American Arbitration Association or at some other professional arbitration company may subject the participants to the management and facility fees of the companies. In addition, even though the California Code of Civil Procedure provides for its own rules of procedure in an arbitration proceeding, such rules will be preempted by any rules agreed to in the arbitration clause. Arbitration clauses must also be carefully reviewed to determine what penalties there may be if you fail to abide by the terms of the arbitration clause. So whether you are in the process of drafting a contract, negotiating a contract, or are involved in a contractual dispute which contains an arbitration clause, the details of the arbitration clause should be carefully reviewed by an attorney to fully protect your present and future interests.

Article Submitted By: Attorney Jennifer Lumsdaine

The Best Defense is a Great Offense

California’s Labor Laws are geared to provide maximum protection to the employees. As an employer, your best defense against costly litigation is a three step process.

First, ensure that your procedures are compliant with both federal and state laws. This includes, but is not limited to, meal and rest breaks, payroll, grievance procedures, and medical/sick leave policies.

Second, ensure that your procedures are in line with what is set forth in your employee manual or other handbook.

Third, ensure that your employment decisions are even handed. Treating employees differently in similar situations can lend to claims of discrimination. Thus, in all decisions you make, you should consider whether it’s a precedent you’re willing to establish.

Tredway, Lumsdaine & Doyle, LLP is available to answer questions or concerns you may have relating to your employment practices and procedures.

Article Submitted By: Attorney Annie Markarian

Contract Disputes Are On The Rise

Contract disputes are on the rise.  I always encourage small business owners to include attorney's fee provisions in all contracts to be able to recoup the expenses of collection or enforcement of agreements.  The precise language, however, must be carefully considered.  In the event the term "reasonable attorney's fees" is used, then the court fixes the fees, thereby leaving open the possibility that the prevailing party will not recoup all of the amount spent.  By contrast, if the term "actual attorney's fees" is used, then the prevailing party can recover the actual amount spent on attorneys.

Moreover, Civil Code section 1717 provides for reciprocity.  In other words, if a contract permits one party to recover attorney's fees, then the provision allows the other party to recover reasonable attorney's fees if it is the prevailing party.  Again, the language of the contract becomes key in the event there are other claims brought not related to the contract, or peripherally related to the contract.  If the provision is broadly written, it is possible for a prevailing party to recover attorney's fees even on non-contractual, tort claims such as negligence.  On the other hand, if the provision is narrowly drawn such as limiting recovery of attorney's fees to actions "to enforce the contract," then the prevailing party will only be able to recover the fees incurred on the contractual claims.   

We can help if you have concerns about the language in your contracts, or if you have a claim in which a contract is involved and would like to know your rights to recovery.

Article submitted by: Attorney Min N. Thai

Business Owners Looking To Sell In The M&A Market

Business owners looking to sell in the M&A market within the last year may have faced a few new issues. First, the lack of available debt financing has reduced sales activity. Second, valuations were at a historical high, but are rapidly decreasing with the current state of the economy.

One way buyers and sellers have bridged this gap is through the use of an earn-out as part of the purchase price. An earn-out is a provision that defers and conditions a portion of the purchase price to the satisfaction of specified milestones.

The earn-out may be very useful to achieve the sale on terms favorable to Buyer and Seller. But, the Seller should beware of a few issues and nuances related to the earn out that may have grave future consequences.

First, what are the terms of the earn-out? An earn-out based on the gross revenue may be the most beneficial to the Seller because it has the fewest calculations to be manipulated. An earn-out tied to net revenue may benefit Buyer as a "truer" test of the success of the company; but changes in cost of goods sold, variances in accounting methods and non- recurring expenses associated with a change in ownership may further lower net revenue calculations.

Second, what is the management structure after the purchase and during the "earn-out"? The owner will want to retain the management team that produced this prosperous company in order to achieve goals and get maximum return on the earn-out. New buyer will want control over the purchased company. These two differing perspectives can be negotiated after term sheet and prior to sale- but they should be considered! Seller may use an employment agreement tied to the terms of the earn-out to ensure continued participation. Voting agreements will also maintain Seller review of the actions of the Board of Directors. The terms of any earn-out tied to employment by the company must also be reviewed for tax consequences, to ensure capital gains treatment to the earn-out as opposed to ordinary income from employment.

Tredway, Lumsdaine and Doyle attorneys have experience in negotiating the ever-changing and evolving world of mergers and acquisitions of closely held companies. If you have questions about selling your business, please call us for further guidance

Article Submitted By: Attorney Brooke Pollard

Your Money In A Declining Economy

In this declining economy, I am always concerned where my clients are putting their money. Cutting costs and minimizing litigation are at the forefront in preserving small businesses. For my clients that are in the business of distribution of name-brand goods, a primary concern is counterfeit goods, or knock-offs. When dealing with new suppliers, I advise distributors to negotiate a situation where the goods are paid upon delivery in order to give the distributor a chance to inspect the shipment for authenticity before paying for the goods. The last thing a small business needs is to have paid for goods only to discover that they are counterfeit after it is too late. Loss prevention is a priority for a small business, and a strategy that we can help implement.

Article Submitted By: Attorney Min N. Thai