A major
corporation hounds you almost to the point of death. You sue. You receive a settlement.
Is it taxable?
Like so much
of tax law, it depends. For example, did the attorney include the magic words
that complete the incantation?
Mr. and Mrs.
French received a deficiency notice for their 2012 tax year. The IRS wanted
$7,231 in taxes and $1,446 in penalties.
At issue was
whether a settlement payment was taxable.
Let’s lay
out the story:
· In 2008 the French’s bought a house.
· Shortly thereafter Bank of America
bought their mortgage.
· In August, 2009 Bank of America
transferred their loan to a subsidiary, BAC Home Loan Servicing.
· In December, 2009 Mr. and Mrs. French
signed a loan modification agreement. The modification was to become effective
February 1, 2010.
A loan
modification means that that payments were temporarily suspended, an interest
rate was changed, the loan term was lengthened and so on. There was a lot of modifications
going on around that time.
· Mrs. French suffered from a very bad
back. She was admitted to the hospital in October, 2009 for surgery.
· From late 2009 into early 2010 Bank
of America began calling the French’s on a routine basis, sometimes up to 5
times a day. They were hounding the French’s that their mortgage was about to
go into foreclosure.
· Mr. French was concerned about the effect
of these endless calls on his wife. He requested that Bank of America call him
on another line, that way he could shield his wife from the stress. Bank of
America couldn’t care less. If anything, they were continued receiving multiple
calls from multiple people across multiple BAC offices.
· Mrs. French went into the hospital in
December, 2009 and again in January, 2010.
· In January, 2010 Mr. French spoke with
a BAC representative. He explained the loan modification. The representative
had no idea what Mr. French was talking about. He explained that – whoever Mr.
French sent the modification to – it was not BAC. He instructed Mr. French to
redo the paperwork, stop payment on the old check and enclose a new check.
· After much hassle, Mr. French was
told that the modification was accepted and that he should start making
payments per the new agreement. He made 10 payments of $1,067.10.
· When she was finally discharged from
the hospital on January 21, 2010, a Bank of America representative called to
tell Mrs. French that “officers were on their way to evict” them.
· On January 23, she started
experiencing chest pain and shortness of breath. She went back to the hospital.
He suffered two pulmonary emboli, passed away twice but was resuscitated. She
was discharged February 4, 2010.
· BAC did not process the first modification
as they promised Mr. French. BAC kept their higher monthly payments and
interest rate. To make matters worse, they posted their monthly payments to a non-interest-
bearing escrow account and treated the payments as if they were processing fees.
· In October 2010 BAC told Mr. French
that they were not honoring the first modification and that the loan was severely
delinquent. They sent a second modification, with conditions and terms
injurious to the French’s. For example, the second modification did not even address
the 10 payments the French’s had previously sent. Mr. French, his back to a
wall, signed the second modification in November, 2010.
· BAC continued, increasing their
monthly payment from $1,067.10 to $1,081.49. In September, 2011, BAC sent the
French’s a notice that their checks would not be applied and would instead be
returned if not for the higher amount.
Finally, the
French’s hired an attorney.
The phone
calls stopped.
The French’s
sued on six claims, alleging fraud, integration of the first and second loan
modifications, punitive damages, additional damages, attorney fees and so
forth.
What they
did not sue for was personal damages to Mrs. French’s health.
They settled
in 2012. The French’s received $41,333, and the attorneys received $20,666.
The French’s
did not report the settlement as income on their 2012 tax return.
The IRS
wanted to know why.
The French’s
presented several arguments:
(1) $7,500 of the settlement was not taxable under
the “disputed debt” doctrine.
If one party does not
agree to the terms of a debt, later settlement does not necessarily mean
income. It may mean repayment of amounts improperly charged the borrower, for
example. An interesting argument, but the Court noted that the settlement
agreement never mentioned disputed or contested debt.
(2) They were being repaid their own money.
(3) IRC Section 104(a)(2)
Except in the case of amounts
attributable to (and not in excess of) deductions allowed under section 213 (relating
to medical, etc., expenses) for any prior taxable year, gross income does not
include-
(1)
amounts received under workmen's compensation acts
as compensation for personal injuries or sickness;
(2) the amount of any damages (other than punitive damages)
received (whether by suit or agreement and whether as lump sums or as periodic
payments) on account of personal physical injuries or physical sickness;
To me, this
was – by far – their best argument.
But it is
one that BAC would never, ever put in writing.
The Court was
however willing to look back to the six claims the attorneys filed for Mr. and
Mrs. French. Unfortunately, the only language it found was the following:
… suffered lost time, inconvenience, distress [and] fear, and have been denied the benefit of the loan modification they were promised, and are being charged too much on their loan.”
These,
folks, are not the magic words to open the Section 104(a)(2) door. For one
thing, the words referred to both Mr. and Mrs. French.
The French’s
owed the tax, but the IRS relented on the penalties.
Too bad the attorneys
did not run the paperwork past a competent tax practitioner before it was too
late.
Our case
this time was French v Commissioner,
T.C. Summary Opinion 2018-36.
