This is the third in a series of articles on issues surrounding the Taxation of Settlements and Verdicts. This article identifies some of the things you can do to protect the character of the award.
Allocate Damages. If a settlement agreement allocates the settlement payment among items taxable as ordinary income, items taxable as a capital recovery and items excluded from taxation, the allocation is generally binding for tax purposes to the extent that the agreement is entered by the parties in an adversarial context, at arms’ length, and in good faith.
IRS and Court May Ignore an Unsupported Allocation. Neither the IRS nor the Courts are required to accept the parties’ allocation and may reallocate the payment to claims they believe are more consistent with the facts. The IRS and the Courts will look to the following information to determine the proper allocation:
Trial Court Judgment;
Drafts of the Settlement Agreement;
Correspondence between counsel, including demand letters, and settlement negotiations;
Communications with third parties including accountants;
Original and Amended Complaints;
Medical Expense Payments.
Risk of No Allocation. Where plaintiff’s complaint includes multiple theories of damages, but the settlement agreement contains no allocation of the award among the various theories, the IRS will take the position that damages, for which the taxpayer was likely to receive an award had the case gone to trial, must be allocated among the types of damages claimed. Rev. Rul. 85-98, 1985-2 C.B. 51. The IRS and the Court will look to, among other things, the pleadings, evidence, and arguments made by the taxpayer in the Court proceedings.
Post-Judgment Settlements. For cases settled after the judgment, the IRS will expect a pro rata allocation of the settlement consistent with the judgment. For example,