1. Taxation of Commercial Litigation
Settlements and Judgments
October 13, 2011
Kevin Kaiser
Co-panelist

2. Outline
• Recognition of income for receipt of settlements and judgments
• General rules for deductibility of settlements, judgments, fines
and penalties
• Special rules for contingent fees
• Deductions for legal fees

3. Taxation of Commercial Litigation Settlements
and Judgments
How Is The Receipt of Income from a Settlement or
Judgment Taxed?
Taxable or Nontaxable?
Capital Gain or Ordinary Income?

4. Tax Treatment of Commercial Litigation Income
• Origin of the Claim Doctrine
o What was the recovery paid in lieu of?
o The recovery should be taxed in the same manner as the item
for which is intended to substitute.
 U.S. v. Gilmore (Sup. Ct., 1963), Origin of the claim
doctrine

5. Tax Treatment of Commercial Litigation Income
• Origin of the claim
o Based on pleadings
o Based on complaint
o Based on settlement agreement

6. Tax Treatment of Commercial Litigation Income
• Origin of the claim
o Lost profits = Ordinary income
o Lost capital = Capital gain income
 E.g., injury to goodwill

7. Tax Treatment of Commercial Litigation Income
Tax considerations should be addressed in advance, BEFORE a
patent infringement, antitrust or other business dispute is
resolved by an agreement or judgment directing the infringer to
pay a sum to the winner.

8. Tax Treatment of Commercial Litigation Income
• Inco Electroenergy v. Commissioner (TC, 1987) Trademark and
patent case
o Amounts received in settlement of trademark dispute and
injury to goodwill were capital gain income
o Trademark and related goodwill are capital assets of the
business
• Taxpayer should make allocation clear in pleadings, complaint,
settlement or other evidence to guide the tax treatment (not
binding on the IRS, but persuasive)

9. Tax Treatment of Commercial Litigation Income
• Freda v. Commissioner (CA-3, 2011) Patent and trade secret
case
o Taxpayers were shareholders of S-corporation that developed
patented process for packaging and distributing uncooked
sausage. Entered into contract to supply sausage to Pizza Hut.
o Taxpayers alleged that Pizza Hut compromised their patented
process and trade secrets. Settlement was reached.
o Amounts paid to settle a misappropriation of trade secrets
claim was taxable as ordinary income, not as capital gain.
• Taxpayer maybe could have made allocation clear in pleadings,
complaint, settlement or other evidence to guide the tax
treatment (not binding on the IRS, but persuasive)

10. Personal Injuries
• Money damages received for personal injuries are taxable unless
received "on account of personal physical injuries or physical
sickness"
• What does "physical" mean? What about,
o Emotional distress
o Reputational harm
o Age, Race, Sex discrimination
o Americans with Disabilities (ADA)
o Wrongful imprisonment

11. Contingent Fees (and contingent fee "income")
• If a plaintiff receives a recovery and simultaneously pays fees to
his contingent fee lawyer, is the client taxed on the net or the
gross amount ?
• The client has gross income on the entire recovery even if the
contingent fee lawyer is paid directly by the defendant and the
client receives only a net check. Commissioner v. Banks (Sup. Ct.,
2005)
• Special "above the line" deduction allowed for contingent fees
paid in connection with certain unlawful discrimination

12. Taxation of Commercial Litigation Settlements
and Judgments
Can a Settlement or Judgment Payment of Damages be
Deducted?

13. Taxation of Settlements and Judgments
• General Rule of Deductibility – current rules
o The payment of a settlement or judgment is deductible if the
taxpayer can prove the expense arises from the active
conduct of a trade or business
o Fines and penalties (i.e., payments made to a government
entity) are generally not deductible
o Public policy considerations should not control the availability
of a deduction for settlements or judgments

14. Taxation of Settlements and Judgments
• Business Deductions – What is ordinary and necessary?
o Ordinary – A business would commonly incur the expense
under the circumstances. Repeated occurrence not
required. May be irregular or once in a business’s life, e.g.,
product liability.
o Necessary – Expense is appropriate and helpful.
o Note – Expenses must be reasonable. Attorney’s fees and
settlement amounts are usually not challenged. Parties are
dealing at arm’s length and litigation, by its nature, is
adversarial.

15. Taxation of Settlements and Judgments
Codified policy based deductions. Four types of expenditures
denied deductions by Congress in 1969:
1. Fine or similar penalty paid to a government for the violation of
any law – section 162(f)
2. Two-thirds treble damages payments under the antitrust laws
following a related criminal violation – section 162(g)
3. Deductions for bribes paid to public officials – section 162(c)(1)
4. Other unlawful bribes or kickbacks – section 162(c)(2)

16. Taxation of Settlements and Judgments
• Section 162(f)
o No deduction shall be allowed under section 162(a) for any
fine or similar penalty paid to:
– U.S. government or State government
– Government of foreign country
– A political subdivision of, or corporation or other entity
serving as an agency or instrumentality of state or
federal government

17. Taxation of Settlements and Judgments
• Section 162(f)
o Fine or similar penalty includes an amount:
– Paid pursuant to a conviction
– Paid as a civil penalty imposed by Federal, state, or
local law
– Paid in settlement of the taxpayer’s actual or potential
liability
Note – does not include legal fees or court costs

18. Taxation of Settlements and Judgments
• What’s not included in the section 162(f) disallowance?
o Settlements and judgments
 Punitive damages
 Compensatory damages

19. Taxation of Settlements and Judgments
Colt Industries, Inc. v. U.S. (CA-Fed Cir., 1989)
• Colt violated Clean Air and Water Act. EPA imposed civil
penalties of $1.6 million
• Deducted on 1979 tax return as ordinary and necessary
business expense
• Service and Claims Court denied deduction under section
162(f). Penalty paid to government

20. Taxation of Settlements and Judgments
Talley Industries, Inc. v. Commissioner (CA-9, 2001)
• Talley mischarged and over charged the government (US Navy)
for work on government contracts. Company accused of fraud
and filing false claims
• Talley paid $2.5 million as restitution under plea bargain and
deducted the payment
• Ninth Circuit allowed $1.56 million deduction, an amount equal
to the estimated government losses (reimbursement/restitution)
• $940,000 was disallowed as a fine

21. Taxation of Settlements and Judgments
Jenkins v. Commissioner (TC, 1996)
• Company fined by North Carolina and Virginia for producing
and selling fertilizer deficient in certain chemicals
• Tax Court found that penalty was imposed to compensate
consumers and was not viewed as punitive. “Penalty” held to
be deductible

22. Taxation of Settlements and Judgments
Legal Fees - A short summary of the tax treatment of paying legal fees
• Can deduct if they arise out of a trade or business;
• Can deduct (subject to limits and thresholds) if they arise out of an
investment activity or something undertaken for profit;
• Can deduct (subject to limits and thresholds) if they relate to tax advice;
• Must capitalize if they relate to capital assets, either held for investment or
use in a trade or business;
• Cannot deduct at all (i.e., no tax benefits) if they relate to personal matters.

23. Q&A