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

California Trust Administration Procedures Seminar

California Trust Administration Procedures seminar in Long Beach, CA on July 16, 2008. The seminar will be held at the The Westin Long Beach located at 333 East Ocean Boulevard.

Your professional advice and trust knowledge is essential to your clients - make sure you're giving them your best. Attend this innovative seminar and learn to juggle trust complexities while remaining focused on what really matters - your clients' needs. Discover ways to recognize the different levels of trust intricacy depending on the type - and value - of the assets involved. You'll learn valuable techniques to improve trust function for everyone involved, as well as tips on managing important legal, tax and family issues. Register today and reinforce your position as a top source for trust service.

This seminar is designed for attorneys, accountants, trust administrators, trust officers, bankers, enrolled agents, financial planners, presidents, vice presidents, paralegals, family office advisors and tax managers.

Two of TLD's prominent attorney's, Mark C. Doyle and Monica Goel, along with other knowledgeable individuals will be presenting at this seminar. Don't miss this opportunity to learn more about how to:

• Expertly handle clients' problems and concerns
• Navigate the relationship between taxation and trusts
• Become an expert on the administrative process
• Keep pace with recent litigation trends
• Avoid harmful mistakes in trust administration

To sign up for this seminar please follow the link below.
California Trust Administration Procedures Seminar Sign Up

Tax Season Comes To A Close: One Way To Lower Tax Liability Of Your LLC.

Many businesses are beginning to understand the flexibility and usefulness of a limited liability company as a way to conduct business within California.  However, with tax season coming to a close, many successful business owners were stunned to discover the Gross Receipts tax levied upon California limited liability companies and foreign LLC's which register to do business in California.

The gross receipts tax is a state tax imposed upon LLC's conducting business in California.  The minimum gross receipts tax for an LLC is $800.  However, the gross receipts tax works on a graduated scale based upon the gross receipts of the company.  Once a company has gross receipts in excess of $250,000, the tax increases from $800 up to $11,970, depending on the level of gross receipts.

Tredway, Lumsdaine and Doyle partner, Mark C. Doyle, with the help of associate Brooke M. Pollard, recently helped an existing LLC convert to a California corporation pursuant to California Corporations Code section 1150 et. seq.  The existing LLC had increased its revenues over the past four years, and was paying in excess of $6,000 per year to the State of California under the gross receipts tax, exclusive of Federal and California income taxes.  By converting the existing LLC to a corporation, the business was able to save significant amounts of money and lower their annual tax liability. 

The conversion of an LLC to a corporation or a corporation to an LLC can have significant tax implications above and beyond the gross receipts tax.  These implications must be reviewed by both the attorney and CPA of the company to determine if this is in the business' best interest.  Please call us if you have any questions or would like additional information about either the gross receipts tax or the conversion of an LLC to a corporation. 

Article Submitted By: Attorney Brooke Pollard

ARC Walk - ARC of Southeast Los Angeles County

A rowdy gang of 34 TL&D supporters showed- up to the ARC Walk on Saturday, April 5, 2008 to show our great support for ARC of Southeast Los Angeles County. TL&D also donated $2,500 to become a diamond sponsor of this special event.

Arc of Southeast Los Angeles County is committed to providing for people with mental retardation and other developmental disabilities the ability to form and work towards goals through training and education, based on their individual abilities. Arc of Southeast Los Angeles County is further committed to helping to reduce and limit the incidence and consequences of mental retardation through education research, advocacy and the support of families, friends and community.

Tredway, Lumsdaine & Doyle has supported ARC for many years through special events such as this, and by hiring people with developmental disabilities as support for the law firm. “Community service is important for any business, but its particularly important for lawyers,” said Joe Lumsdaine, senior partner for the firm, “Lawyers serve in a privileged position. They should be willing to support the community in return.”

Another Tax Tip

When two separate, determining which parent is going to take the children as exemptions, look to the custody agreement/order first. The parent with greater than 50% custody is entitled to take the exemption. The parents that are on a true shared schedule, on alternating weeks for example, then the parents can each take one of the children (for 2 children) in the same year or alternate each year (e.g. for 1 or 3 children).

It only makes sense to release the exemption to the lower timeshare parent if it maximizes the collective tax benefit. This is because once an exemption is released, the child support under California law should be recalculated upward  to reflect the tax benefit the lower timeshare parent is receiving.  The Court may order the exemption to be released in limited situations. Because of the progressivity of the federal income tax, "the higher a taxpayer's income, the more valuable exemptions become .... As a result, the effect of awarding the exemption to the noncustodial parent is to increase the after-tax spendable income of the family as a whole, which may then be channeled into child support. ...” [Monterey County v. Cornejo (1991) 53 C3d 1271, 1280, 283 CR 405, 411]

When the exemption is released, it is important the child support order also clarifies that the release be conditioned on being current on support for that tax year. The noncustodial parent will want to have a condition that the custodial parent will cooperate in signing the IRS 8332 form required when the tax returns are filed with the exemptions that are taken.

Article Submitted By: Attorney Daniel Gold

TAX RETURN PLANNING DURING THE SEPARATION PERIOD

As the end of the year steadily approaches and you begin organizing and/or gathering documents to assist in your upcoming tax preparation for the 2006 fiscal year, you may want to consider whether you and your spouse are going to file married jointly or married filing separately.

Disadvantages of Separate Returns:  Married couples who file jointly are taxed as if each spouse had exactly the same taxable income.  Accordingly, substantial tax savings are realized by filing jointly.

Different tax rates on separate returns; earnings taxed separately: If you are separated from your spouse but still legally married by the end of 2006, you must file separately unless you and your spouse agree to file a joint return or a court has entered a judgment of legal separation.  A later obtained judgment or marital dissolution does not relate back to an earlier year in which you and your spouse were married.

You and your spouse will each be taxed on your respective earnings separately.  But you will each have to allocate income, treating income earned before the date of separation as community property (taxable half to each) and income earned after the separation date as the earning spouse's separate property.  If all income is community income so that the income and deductions are divided equally among you and your spouse, the total tax on separate and joint returns will be the same.

Restrictions on itemized deductions and child care credit: If you and your spouse file separate returns, you both must agree to itemize deductions.  If not, then neither can.  IRC Section 63(e)(1).  No child credit may be claimed on a spouse's separate return unless the other spouse was absent from the household during the last six months of the year.  IRC Section 21(e)(4)

Allocation of tax liability: Separated spouses who are willing to file jointly should reach a clear agreement as to how the tax liability will be apportioned between them.  A logical approach is to prorate the tax liability by using a ratio based on the parties' separate incomes.  In the alternative, spouses may chose to allocate liability based on what each would have paid if separate returns were filed.

Relief from tax liability: Generally, spouses who sign a joint return are each jointly and severally liable for the tax shown on that return, including any tax deficiencies, interest and penalties attributable to the other spouse.  The liability exposure should be kept in mind when deciding whether to file jointly or separately.

Potential joint liability relief: A spouse wrongfully exposed to joint liability for deficiencies, interest and penalties may have recourse under an indemnification agreement or under various code provisions.  For example: (1) 'Innocent Spouse' relief from liability for tax deficiencies attributable to erroneous items of the other spouse (IRC Section 6015(b)); (2) 'Separate liability' relief from liability for tax deficiencies (IRC Section 6015(c)); and Equitable relief from liability for tax deficiencies and underpayments (IRC Section 6015(f)).

Helpful assistance can also be found at the IRS Web site http:/www.irs.gov.