Investment loss lawsuits ramp up post-Facebook faceplant

By Robert W. Wood

The Facebook IPO made history on its launch. Then it made history again with its precipitous market decline. As a result, the lawsuits are flying. More than a few lawyers and clients are surely hoping to get in on the rush. And that could prompt not only recoveries from this historic stock offering but some spillover effects into other investment loss cases too. To me, that means taxes.

If you or a client lost money and managed to pull off a recovery, will it go into your pocket or must you split it with the Internal Revenue Service? That will depend on the facts and on your underlying tax position. Surprisingly, the legal theory is usually not very important. Suppose you claim that your stockbroker, investment adviser, real estate investment trust or mutual fund (i.e., any company in which you invest) causes you to lose money. If you make a claim via a lawsuit or arbitration you may have the happy problem of determining how your recovery is taxed.

Many investment loss claims are brought as National Association of Securities Dealers arbitration proceedings even though the claimant would probably rather proceed in court. Whether the matter involves an arbitration claim, an individual court case or a class action, the basic theory is likely to be the same: The defendant caused the plaintiff to lose money. The legal grounds for the claim may involve alleged breaches of fiduciary duty, churning, violations of the securities laws, RICO, simple failures to diversify, negligent or fraudulent accounting practices, etc.

Suppose you bought Facebook stock for $38. Let's say when the stock drops to $28, you make a claim and eventually get back $5 in a settlement. Do you have to report it as income? Like so much else in the tax world, it depends. An investor settling a claim that he lost money because of bad conduct by a company, bank or brokerage firm ordinarily has an incentive to assert the loss was capital in nature and that any resulting settlement should be capital too.

The IRS, on the other hand, has an incentive to argue for ordinary income treatment. To resolve this standoff, look to the origin of the claim. It controls the tax treatment of a recovery from a lawsuit.

In investment loss cases, the plaintiff will generally assert that the recovered funds are nontaxable as a recovery of basis, or represent capital gain. Usually, this invites questions into what the plaintiff has already done on his tax return in relation to this investment loss. If the plaintiff has already claimed a tax loss on the investment, then that tax loss must be taken into account in determining how the proceeds of any ultimate recovery will be treated.

In the typical investment loss case, the plaintiff claims that the defendant's conduct (accounting problems, mismanagement, conversion, fraud, etc.) lead to the loss or diminution in value of the plaintiff's investment. The IRS is always on the lookout for double benefits. The plaintiff should not get favorable taxation on the recovery and also get a tax deduction for the investment loss.

One key issue is what triggers capital gain treatment. A capital gain is generally defined by reference to the gain on the sale of a capital asset. The mere settlement of a lawsuit is usually not a disposition. However, the courts and IRS have often allowed capital gain treatment for litigation proceeds even though you still hold the investment.

Suppose you bought Facebook stock for $38, it drops to $20, and you later recover $15. Depending on your facts, it might be treated as a recovery of your basis and therefore fully nontaxable even if you still hold the stock.

Here is a more comprehensive example:

Ivan Investor purchases stock in Conglomerate for $500 per share. Over the course of the next several years, Conglomerate stock climbs to $1,000 per share. Then, as a result of bad management and fraud, Conglomerate stock becomes worthless. Thus Ivan has a loss of $1,000 per share. Ivan brings a securities action against Conglomerate and its banks. He eventually recovers $500 per share in a settlement. Ivan can treat the $500 recovery a basis recovery and not as income.

Assume the same facts but that after Ivan has commenced a suit against Conglomerate and its banks, he claims a worthless securities loss for the shares on his tax return. After all, he may never recover in the securities lawsuit. Recall that Ivan's basis was $500 per share, and the market value of his stock was once $1,000 per share. Thus, he has an economic loss of $1,000 per share. Under the worthless securities loss rules, Ivan claims a loss for $500 per share. Eventually, Ivan recovers $500 per share in a settlement with Conglomerate and its bankers. Although Ivan's stock became worthless, none of the $500 settlement can be treated as a basis recovery. After all, Ivan already wrote off his investment as worthless.

Thus, the $500 constitutes income. Whether it is ordinary or capital might be debated, but Ivan should be able to claim the entire $500 as capital gain since it relates to his underlying Conglomerate stock.

Many investors today recover amounts related to investments. More companies, banks, brokerage firms and investment advisers fall subject to these claims. Facebook may actually trigger more such claims. The tax issues for the recovering plaintiffs often involve ordinary income versus capital gain, and gain versus basis recovery. The income tax stakes can be quite large and can sneak up on you if you're not careful. Lawyers and their clients should both beware.

This discussion is not intended as legal advice, and cannot be relied upon for any purpose without the services of a qualified professional.

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