A Firefighter Sues

The taxation of legal settlements can be maddening.

The general rule is found in IRC Section 61, which can be colloquially summarized as:

If it breathes, moves, or eats, it is taxable.

Then come the exceptions.

The Code begins with a broad rule, and then you must find and fit into an exception to avoid taxability. A big exception for legal settlements is Section 104(a)(2):

        § 104 Compensation for injuries or sickness.

(a)  In general.

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;

What can we learn here?

(1) The Code does not care whether the judge decides or if the parties instead come to an agreement.  

(2)  It does not care if one gets paid in a lump sum or in a series of payments.

(3) It cares very much that the settlement is for something physical – whether injury or sickness.  

What about something nonphysical, such as mental or emotional distress?

Reviewing the history of the Code helps here, as we learn that the Code was changed in 1996 to clarify that mental and emotional injury settlements are excludable from income only if they arose from physical injury or sickness.

This gives the following rule of thumb:

          Physical               =       nontaxable

          Nonphysical        =       taxable      

The attorney must be aware of the above demarcation and wordsmith accordingly if some or all the settlement is for nonphysical damages. 

Can it be done?

Let’s look at the Montes case.

Suzanne Montes wanted to be a firefighter since she was a little girl. She was one of the few women to pass the exam to get into the San Francisco Fire Academy. She then was one of the few women to graduate from the program.

Good for her.

In 2016 she received a sweet assignment to a firehouse in downtown San Francisco.

You may know that firefighters work as a team and in 24-hour shifts. There are about 10 shifts per month, so they spend a LOT of time together. Suzanne was a woman. The remainder of the team were men. Many did not welcome her. First came the disparaging comments, then sabotaging her equipment, then doing - I do not know what specifically and I do not want to know – “disgusting and extremely unsanitary” things to her personal property and effects.

Thanks, guys, for painting men as knuckle-dragging Neanderthals. Way to represent the team.

She complained.

She sued.

She won approximately $380 grand.

Good.

She went to a CPA when it was time to file. The CPA advised that the $380 grand was not taxable.

Even better.

You know the IRS balked, as we are looking at a Tax Court case.

The IRS’s first argument?

Start with the complaint, which claimed sex discrimination and retaliation, including the intentional infliction of emotional distress.

There are no allegations of physical disease or harm to her in the complaint.”

We are not seeing the magic words here: physical injury, physical sickness or micrato raepy sathonich.

Hopefully her attorney salvaged this in the settlement agreement.

Here is the Court:

Our detective work here begins and ends with the settlement agreement.”

Oh oh.

There are no allegations of physical injury …, and indeed, in the summary of the complaint it says, ‘She has lost compensation for which she would have been entitled. She has suffered from emotional distress, embarrassment, and humiliation and her prospects for career advancement have been diminished.’”

No magic words.

Yep, she lost her case. The settlement was taxable.

The Court did hand her a small victory, though. Penalties did not apply because she took a reasonable position based on the advice of a CPA.

Our case this time was Montes v Commissioner, Docket No. 17332-21, June 29, 2023.

 

Income, Clearly Realized

 

What is income?

Believe it or not, there is a line of cases over decades developing the tax concept of income.

Some instances are clear-cut: if you receive wages or salary, for example, then you have income.

Some instances may not be so clear-cut.

For example, let’s say that you receive a stock dividend. The company has a good year, and you receive – as an example – 1 additional share for every 5 shares you own.  

Do you have income?

Let’s talk this out. Let’s say that the company is worth $25 million before the stock dividend and has 1 million shares outstanding. After the stock dividend it will have 1.2 million shares outstanding. What are those extra 200,000 shares worth?

This is an actual case – Eisner v Macomber - that the Supreme Court decided in 1920. Congress had changed the tax law to tax this stock dividend, and someone (Myrtle Macomber) brought suit arguing that the law was unconstitutional.

Her argument:

·      The company was worth $25 million before the dividend

·      The company was worth $25 million after the dividend

·      She may have more shares, but her shares represent the same proportional ownership of the company.

·      She did not have any more money than she had before.

She had a point.

The Bureau of Internal Revenue (that is, the IRS) came at it from a different angle:

There was income – the income generated by the company.  The company was “distributing” said income by means of a stock dividend.

The Court reasoned that one could have income from labor or from capital. The first did not apply, and it could find nothing to support the second had happened to Mrs Macomber.

The Court decided that she did not have income.

Let’s continue.

The Glenshaw Glass Company sued the Hartford-Empire Company for damages stemming from fraud and for treble damages for business injury.

The two companies settled, and Hartford was paid approximately $325 thousand in punitive damages.

Glenshaw had no intention of paying tax on that $325 grand. That money was not paid because of labor or because of capital. It was paid because of injury to its business - returning Glenshaw to where it should have been if not for the tortious behavior.

Not labor, not capital. Glenshaw was draped all over that earlier Eisner v Macomber decision.

But the IRS had a point – in fact, 325 thousand points.

Here is the Court:

Here we have instances of undeniable accessions to wealth, clearly realized, and over which taxpayers have complete dominion. The mere fact that the payments were extracted from the wrongdoers as punishment for unlawful conduct cannot detract from their character as taxable income.”

The Court levered away from its earlier labor/capital impasse and clarified income to be:

·      An increase in wealth

·      Clearly realized, and

·      Over which one has (temporary or permanent) discretion or control

In time Glenshaw has come to mean that everything is taxable unless Congress says that it is not taxable. While not mathematically precise, it is precise enough for day-to-day use.

I have a question, though.

At a conceptual level, what are the limits on the “clearly realized” requirement?

I get it when someone receive a paycheck.

I also get it when someone sells a mutual fund.

But what if your IRA has gone up in value, but you haven’t taken a distribution?

Or the house in which you raised your family has appreciated in value?

Do you have an increase in wealth?

Do you have discretion or control over said increase in wealth?

Do you have “income” that Congress can tax under Glenshaw?

JPMorgan's Nondeductible Madoff Deal

On January 7, 2014, JPMorgan entered into a deferred prosecution agreement with the Justice Department. This is another payment in the ongoing Bernie Madoff saga, and the bank agreed to pay a $1.7 billion settlement as well as $350 million to the Office of the Comptroller of the Currency and $543 million to a court-appointed trustee.

Madoff kept significant balances with JPMorgan.  Banks are the first line of defense against fraud, but JPMorgan never filed suspicious activity reports with regulators, even though there were significant reservations as to when they became suspicious. The bank did not admit any criminal activity in the agreement, but it did allow that it missed red flags from the late 1990s to late 2000s.

What caught my eye was the following text from the following joint release by the Manhattan U.S. Attorney and FBI:
           

… JPMorgan agrees to pay a non-tax deductible penalty of $1.7 billion, in the form of a civil forfeiture, which the Government intends….”

This is unusual language.

The tax code provides a tax deduction for all of the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.

And then the tax Code starts taking back. One take back is Section 162(f):

162(f) FINES AND PENALTIES.— No deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law.

Let’s drill down a little bit into the Regulations:

This prohibition applies to any fines paid by a taxpayer because the taxpayer has been convicted of a crime (felony or misdemeanor) in a full criminal proceeding in an appropriate court.   The prohibition also extends to civil fines if the fines are intended by Congress as punitive in nature.

So, if fines are paid pursuant to a criminal case, then the taxpayer is hosed. However, if fines are paid pursuant to a civil case, there is one more step: are the fines punitive in nature?

Attorneys differentiate damages between those that are remedial and those that are punitive. A remedial payment is intended to compensate the government or another party – to “make one whole,” if you will. It is intended to restore what was disturbed, upset or lost, and not intended as penalty or lashing against the payer.

Let’s complicate it bit. There is a court case (Talley Industries Inc v Commissioner) that allows damages to be deductible if they are remedial in intent, even if labeled as a fine or penalty.

EXAMPLE: The NFL fines a player for unnecessary roughness. The NFL can call this a fine, but it is not a fine per Section 162(f) and will be deductible to the player involved.

You are seeing how this is fertile hunting ground for tax lawyers. Unless the payment is pursuant to a criminal case, odds are good that it is deductible.

Now remember that this agreement is Madoff related, and that there are hard feelings about JPMorgan’s involvement with Madoff over the years, and you can see why the Justice Department included the “nondeductible” language in the agreement.

Let’s take this a step further. Under Talley, JPMorgan could deduct the $1.7 billion on its tax return. Remember, it is not a fine or penalty under Sec 162(f) just because somebody somewhere called it as such.

Would JPMorgan be likely to do this?

This is a “deferred prosecution” agreement.  If JPMorgan did deduct the settlement, they might not have an issue with the IRS, but they would likely have a very sizeable issue with the Justice Department.