Tax
May 26, 2001
Uncertain Recovery
Can litigation damages awarded to a plaintiff (punitive or compensatory) be assigned to a third party without creating income to the assignor? This question - to a tax lawyer anyhow - would seem to answer itself, and the answer would appear to be a resounding "no."
Robert W. Wood
Managing Partner, Wood LLP
333 Sacramento St
San Francisco , California 94111-3601
Phone: (415) 834-0113
Fax: (415) 789-4540
Email: wood@WoodLLP.com
Univ of Chicago Law School
Wood is a tax lawyer at Wood LLP, and often advises lawyers and litigants about tax issues.
Can litigation damages awarded to a plaintiff (punitive or compensatory) be assigned to a third party without creating income to the assignor? This question - to a tax lawyer anyhow - would seem to answer itself, and the answer would appear to be a resounding "no."
The assignment-of-income doctrine has long plagued taxpayers, in part because its timing has always been confusing. A taxpayer cannot avoid income by trying to assign it after it is earned. So, if someone is entitled to a paycheck, but tells his employer to give it to his daughter instead, the income is still his for tax purposes (even if his daughter spends all of the money).
The Internal Revenue Service recently has enjoyed reinvoking the assignment-of-income doctrine in cases dealing with attorney fees paid to contingent-fee lawyers.
An important recent letter ruling, Priv. Ltr. Rul. 200107019, Tax Analysts Doc. No. 2001-4799, 2001 TNT 34-19 (Nov. 16, 2000), takes a look at an assignment by a plaintiff of rights to litigation proceeds. Private letter rulings are issued to one particular taxpayer and technically cannot be cited as precedent. Yet they are widely looked upon by tax professionals as showing the position of the IRS, and the U.S. Supreme Court has even cited private letter rulings. See Rowan Cos. v. United States, 452 U.S. 247 (1981).
In Ruling 200107019, the IRS ruled that a portion of the punitive damages that a couple was awarded (but that they transferred in advance to a charitable trust before receipt) was not includable in the couple's income.
The case arose out of the death of the couple's son in a car accident. The couple entered into a contingent-fee agreement with an attorney to prosecute claims for the wrongful death of their son. The plaintiffs created a tax-exempt charitable trust and assigned to it any punitive damages that they might be awarded in excess of attorney fees. This assignment was made when it was unclear whether there would be any punitive damages. After the trial and the appeals, the defendant eventually paid.
The ruling not only refers to general principles regarding assignment of income but also considers situations in which a transferred claim is required to be taken into income by the transferor.
According to the ruling, although anticipatory assignment-of-income principles require a transferee to include the proceeds of a claim in gross income where the recovery on a transferred claim is certain at the date of transfer, this does not apply where the recovery is doubtful. If, as of the date of the transfer of the claim, the recovery is doubtful or contingent, the assignment-of-income doctrine does not require the transferor to pick up the income.
In Doyle v. Commissioner, 147 F.2d 769 (4th Cir. 1945), a taxpayer assigned 60 percent of a claim he owned to his wife and children. This assignment was made after the Court of Claims denied an application for a new trial and the U.S. Supreme Court denied the taxpayer's petition for certiorari. The IRS argued at this point that the gain the taxpayer expected to receive was "practically assured." The court agreed.
Another case following the same approach (but under considerably more favorable facts) is Cold Metal Process Co. v. Commissioner, 247 F.2d 864 (6th Cir. 1957). The underlying case was a patent-infringement suit with multiple defendants. During the pendency of an the appeal, several defendants settled.
The court in Cold Metal found that the matter was a continuing controversy when a portion of the judgment was assigned to the charitable trust. Rights to the funds could not be established while the government was appealing strenuously. The Cold Metal case demonstrates the doubtful and contingent nature of any lower-court judgment during an appeal.
The IRS also considered Jones v. Commissioner, 306 F.2d 292 (5th Cir. 1962), involving a claim assigned to third parties. The taxpayer-assignor was held not taxable on the award because the claim was contingent and doubtful when it was assigned; no gift was involved to trigger the potential imposition of the gift tax; the assignment was made prior to the year in which income could be treated as received; and the assignment arose out of the exercise of a legitimate business purpose.
In Schulze v. Commissioner, T.C.M. 1983-263 (1983), the tax dispute arose out of an underlying dispute between the taxpayer (a lawyer) and his law partnership. The taxpayer sued his former law partnership for damages. The taxpayer and his wife divorced during the pendency of this suit, and the taxpayer's claim against the law firm was divided between the former partner and his spouse in the divorce. Eventually, the taxpayer recovered and paid a portion to his former spouse.
The IRS argued he was taxable on all of it, including his former wife's share. The Tax Court held that the assignor-taxpayer was not taxable on monies paid to his former spouse based on the same four points made in Jones.
The court in Schulze noted that the outcome of a lawsuit is rarely (if ever) free from doubt. Since the assignment was made before a decision was rendered, the court found the assignment-of-income doctrine inapplicable.
Because the assignment in Ruling 200107019 was held to be effective, the couple did not have to take the settlement (in this case, punitive damages) into income first and then claim a deduction for a charitable contribution. The difference in tax result can be huge. Common sense might dictate that taking $5 into income and then deducting $5 ought to put one back to zero. But that is not the way the rules work.
Deductions for charitable contributions are only available as miscellaneous itemized deductions, and itemized deductions are deductible only in excess of 2 percent of adjusted gross income. For high-income taxpayers, there is also a phase-out of itemized deductions and exemptions. Charitable-contribution deductions are also subject to specific percentage limits, which were avoided by this assignment.
The presence of these problems makes an assignment of the type that was successfully employed in Ruling 200107019 terribly interesting. Although the alternative minimum tax doesn't apply to charitable contributions (which have their own set of percentage restrictions), all of the above-listed restrictions, including the alternative minimum tax, apply to attorney fees and many other items. This should make litigants think about what they intend to do, assuming that their suit is successful.
Ruling 200107019 refuses to give effect to the attempted assignment of monies to the attorney. Some circuit courts have held that there is no need for the plaintiff to take the attorney's money into income and then deduct it. These circuits include the 5th (Cotnam v. Commissioner, 263 F.2d 119 (5th Cir. 1959)), 11th (Davis v. Commissioner, 210 F.3d 1346 (11th Cir. 2000)) and 6th (Estate of Clarks v. United States, 202 F.3d 854 (6th Cir. 2000)).
In the other camp are the courts that hold that the taxpayer-plaintiff must take into income the payment to the lawyer, even if the lawyer is paid directly. These circuits include the 1st (Alexander v. Commissioner, 72 F.3d 938 (1st Cir. 1995)), Federal (Baylin v. United States, 43 F.3d 1451 (Fed. Cir. 1995)) and 9th (Benci-Woodward v. Commissioner, 219 F.3d 941 (9th Cir. 2000), and Coady v. Commissioner, 213 F.2d 1187 (9th Cir. 2000)).
In Kenseth v. Commissioner, 114 T.C. 26 (2000), the Tax Court thoroughly examined this issue, and 13 Tax Court judges participated in the decision (unlike the normal Tax Court case where only one judge decides). This "reviewed by the court" status makes Kenseth important. But eight out of 13 judges felt that the plaintiff-taxpayer had to include the amount in income and then claim a deduction for it. These judges felt that it was up to Congress to change the rules about deductions and their value, even if the alternative minimum tax basically eviscerates the deduction.
Still, five Tax Court judges felt this was wrong and that Congress did not need to do anything to fix it. These five Tax Court judges make it possible that the law will change in the future. Plus, the U.S. Supreme Court may be required to face this issue. It is even possible that the alternative minimum tax will be either significantly modified or entirely repealed. In this year of tax legislation, a repeal of the that tax might be the quickest fix of all.
Whatever occurs with respect to the deductibility of legal fees, Ruling 200107019 should be considered by plaintiffs who anticipate a significant recovery. It offers the possibility of a gift to charity in advance of the recovery (that would escape the normal limitations on charitable contributions). This letter ruling may even offer the possibility of transfers to family members and others before a judgment becomes final.
Robert W. Wood practices in San Francisco. He is a certified specialist in taxation and the author of "Taxation of Damage Awards and Settlement Payments" (Tax Institute 2nd ed. 1998).
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