by Jerry Meek
The “silent lien” of the IRS
Most plaintiffs’ lawyers know that, when Medicare or Medicaid has paid for the treatment of an injured client, the lawyer has an obligation to satisfy any Medicare or Medicaid liens before distributing the proceeds of a settlement or judgment.
But what about when the client owes money to the IRS? Under IRC § 6321, when the IRS demands that a tax be paid, and the tax isn’t paid, a general tax lien automatically arises against all of the taxpayer’s “property and rights to property.” This includes a client’s unliquidated interest in a potential lawsuit. In fact, the lien even attaches to after-acquired property – including a potential lawsuit arising out of an injury that hasn’t yet occurred.
A general tax lien is sometimes called “a silent lien” because there may be no public record of the obligation. While the IRS sometimes will file a “notice of federal tax lien” (NFTL), the lien attaches regardless of whether such a notice is filed. Filing a NFTL serves only to give the IRS enhanced priority over certain types of competing creditors.
What is obviously a problem for your client could become your problem as well. Under 31 U.S.C. § 3713, a lawyer who distributes the proceeds of a settlement or judgment, with knowledge or notice of the existence of a tax lien, may be personally liable for the amount of the tax (up to the amount of the distribution). In addition, if your client is a personal representative who distributes proceeds to a beneficiary knowing that the beneficiary is subject to a tax lien, the personal representative can be personally liable for the tax. The personal representative may then seek to recoup her losses by suing you.
The Courts have consistently held that a beneficiary’s renunciation of the right to receive wrongful death proceeds will not defeat the lien. Instead, the IRS can follow the proceeds and recover from the substitute beneficiary.
Clients – and even lawyers – may mistakenly believe that no lien exists until a NFTL is filed. As a result, when asked whether they have any tax liens against them, clients may honestly say they don’t. Don’t ask about liens. Instead, ask your client whether the IRS has told them they owe any tax. If so, ask your client to execute IRS Form 8821 so that you can get information directly from the IRS about the amount owed.
There is one silver lining for the plaintiff’s lawyer. Under IRC § 6323(b)(8), even if a NFTL has been filed, an attorney’s lien against the proceeds has priority over the IRS’ lien. Even the IRS doesn’t expect you to work for free.
When are damages tax-free?
Compensatory damages are tax-free, right? Well, it depends.
Under IRC § 104(a), gross income does not include “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.” Damages for “emotional distress” are excluded from income only to the extent of any medical expenses actually incurred for the treatment of the emotional distress to which the damages are attributed. Treasury Regulations add that, to be excluded from income, the damages must be for an action or potential action to vindicate some “tort or tort type rights.”
Congress added the term “physical” in 1997. This amendment only added further controversy over a provision that has been a frequent source of litigation for the IRS. Two issues are at the forefront. First, when is an injury or sickness physical? Second, when – and to what extent – are the damages on account of such injury or sickness?
On the first point, the Courts consistently hold that mental pain and anguish – in itself – is not a physical injury or sickness. The Tax Court has held that being handcuffed and searched did not constitute a physical injury, nor did being physically restrained or detained. And remarkably, in 2000, the IRS issued a private letter ruling finding that there was no physical injury within the meaning of § 104 where, according to the taxpayer, the employer “assaulted” her and caused her “extreme pain,” but the taxpayer’s doctors found nothing to be “physically wrong” with her.
What if there is a clear physical injury resulting in non-physical damages? As a general rule, as long as the primary injury or sickness is physical in nature, all damages secondary to that injury or sickness can be excluded from income. This may include, for example, compensation for lost wages or compensation for pain and suffering. Which injury is primary and whether the damages received are in fact secondary to the primary injury are fact driven determinations which in some cases may be difficult.
Importantly, punitive damages and interest are always taxable. (Ironically, until 1953, punitive damages were not considered income, on the grounds that they were a “windfall” and thus not attributable to labor or capital). In addition, even if the settlement or judgment is otherwise tax-free, your client may be required to pay tax on all or some of it if he deducted medical expenses attributable to the injury on a prior tax return. As a result, to accurately tell a client that a recovery will be tax free, you have to ask about any prior year deductions.
Finally, under the constructive receipt doctrine, when a judgment or settlement is taxable, your client generally must include it in income for the year in which it is received by you, as the client’s agent. Thus, if a settlement check arrives in your office on December 28, 2011, your client generally must report the settlement on her 2011 return, even though you do not distribute the funds to her until 2012.
Settling on tax consequences when settling
When a settlement is reached on a claim for which part or all of the damages may be tax-free, the settlement agreement should state the parties’ intent with respect to any tax consequences. While neither the IRS nor a Court is obligated to accept this statement, your position is almost always markedly improved by spelling it out.
The tax implications of a settlement agreement hinge largely on the intent of the parties to the agreement. As Courts often explain, the critical question is, “in lieu of what was the settlement amount paid?” To what extent was the payment made on account of physical injury or sickness? To what extent was it made on account of something else?
While a Court will not blindly accept the parties’ allocation, so too it will not speculate as to the parties’ intent. The clearest indication of the parties’ intent is the settlement agreement itself. As a result, when adversarial parties enter into a settlement agreement, at arm’s length and in good faith, the Courts typically accept the allocation agreed upon. If the agreement is silent, then the Court will make this determination for itself, based upon the facts and circumstances, including the pleadings, the evidence presented, and the course of negotiations.
When the agreement is silent, Courts have proven to be very creative in reaching their own conclusions. After former NBA player Dennis Rodman kicked a television cameraman in the groin, a lawsuit was averted when Rodman agreed to pay $200,000. The cameraman claimed the entire settlement was tax-free; the IRS argued that only $1 dollar should be tax-free. The settlement agreement contained no statement about the tax consequences. Relying upon the text of the settlement agreement, a declaration by Rodman, and the testimony of the cameraman’s attorney, the Tax Court concluded that $120,000 was paid on account of physical injuries. The remaining $80,000, however, was paid for the cameraman’s agreement not to defame Rodman, publicize the facts of the incident, or assist in criminal prosecution. This part, the Court concluded, was taxable.
In addition to the deference that Courts typically give the settlement agreement, there are two other reasons to specify the allocation in the agreement. First, the IRS will not be a party to your settlement agreement. Thus, the parties’ allocation will almost invariably be more favorable to the payee than any allocation the IRS will propose. Second, while the payee’s intent is a factor, the Courts have consistently held that it is ultimately the payor’s intent which is dispositive. After the settlement is concluded, the payor will have little interest in cooperating with the payee. Demand that cooperation when negotiating the settlement.
Don’t forget, however, that the parties’ allocation must be in good faith and at arm’s length. Thus, when a case settles on appeal, after a substantial verdict for punitive damages, a Court may refuse to accept that none of the settlement should be allocated for punitive damages. Similarly, if the settlement agreement allocates damages based upon a theory that was never alleged in the Complaint, a Court may refuse to defer to the expressed intent of the parties. The moral: spell it out, but don’t overreach.
Your clients may have to include your fees in their income
Your client will likely assume that, if her settlement or award is taxable, she can at least exclude from her income whatever contingency fee goes to you. She would be wrong.
If the entire settlement or award is tax-free, then there’s no issue. That’s because if the entire award is tax-free, so too is any portion of the award that is ultimately paid to you in fees. The issue arises when a settlement or award is either partially or entirely taxable. In Commissioner v. Banks, the Supreme Court, resolving a conflict among the circuits, held that, as a general rule, when a litigant’s recovery constitutes income, the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee.
Obviously, if you represent a client litigating a matter in connection with her trade or business, she can likely deduct the fees fully under IRC § 162. Similarly, under the American Jobs Creation Act of 2004, plaintiffs who recover on claims for “unlawful discrimination” (including claims for retaliatory discharge or whistleblower claims) can take an above-the-line deduction, which is treated more favorably than other deductions.
All other plaintiffs facing taxable settlements or awards aren’t so lucky. They can only claim a miscellaneous deduction, under IRC § 212(1), for expenses paid “for the production or collection of income.” Such miscellaneous deductions can be sharply limited. Only those miscellaneous deductions in excess of 2% of adjusted gross income can be deducted. The remainder is lost. In addition, miscellaneous deductions are not permitted for purposes of the alternative minimum tax, dramatically increasing the likelihood that your client will be unable to take advantage of the deduction. Finally, although the phase-out of itemized deductions is currently suspended, it is slated to return in 2013. At that point, high-income taxpayers – which could include any client receiving a substantial taxable settlement or award – may be unable to fully use the deduction.
The injustice of this result is even more apparent when one considers that, even though the settlement or award may be designed to compensate for years of harm, it will often be paid in a single year. This could push your client into a tax bracket much higher than he or she would otherwise enjoy, resulting in even more taxes paid.
What if the settlement or award is only partially taxable? The IRS takes the position that, under these circumstances, your fees should be allocated pro rata between the taxable portion and the non-taxable portion of the award or settlement. But this is certainly not set in stone. Courts have, for example, approved allocations based upon how the attorney spent his or her time in the case. As a result, if your action includes claims for relief, some of which may result in a taxable award, it would be prudent to keep track of your time and activities, in the event that a non pro rata allocation results in more favorable tax treatment.
You can’t deduct your litigation costs
Under IRC § 162, a business can deduct its “ordinary and necessary” business expenses. Plaintiffs’ lawyers often incur extraordinary out-of-pocket costs in developing and working a client’s case to its conclusion. When the expenses on a case are paid or incurred over multiple tax years, the ability to immediately deduct the expenses may allow for deferral of taxes owed.
Even though litigation costs are undeniably ordinary and necessary expenses incurred in the conduct of a trade or business, the Plaintiffs’ lawyer cannot deduct these costs. That’s because the IRS contends – and the Courts generally agree – that these costs are paid by the client, not by you. Rule 1.8(e) of the Model Rules of Professional Conduct provides that “a lawyer shall not provide financial assistance to a client in connection with pending or contemplated litigation, except that . . . a lawyer may advance court costs and expenses of litigation, the repayment of which may be contingent on the outcome of the matter.” By using the word “advance,” the Rules of Professional Conduct clearly contemplate that your litigation costs are a loan to your client, to be repaid (if at all) upon successful resolution of the case.
The idea that your litigation costs are a loan to the client is somewhat counterintuitive. After all, repayment is contingent upon successful resolution of the case. It’s easiest to think of this as a non-recourse loan, in which the collateral is the client’s claim. Like any non-recourse loan, the creditor can only look to the collateral for recovery. But it’s still a loan.
The act of receiving or extending a loan is a non-taxable event. Thus, while you cannot deduct your litigation costs, similarly you need not include in your income the recovery of the “loan” when the case is resolved.
One State has revised its Rules of Professional Conduct so that litigation costs can be deducted. Under Alabama’s Rule, as amended in 1995, where there is a contingency fee, “a lawyer may pay, for his own account, court costs and expenses of litigation. The fee paid to the attorney from the proceeds of the action may include an amount equal to such costs and expenses incurred.” Since in Alabama the litigation costs are paid by the lawyer for his own account, the costs are not mere loans. They are therefore currently deductible.
What happens if you don’t recoup your litigation costs out of the settlement? Since your costs were a loan, you are entitled to a bad debt deduction, under IRC § 166(a), in the year in which your loan became worthless.
Unfortunately, this view of litigation costs creates other tax problems which are not fully resolved. For example, when a taxpayer’s debt is cancelled by a creditor, the taxpayer generally must include the amount of the discharged debt in her income. If a case is lost and the attorney forgives the costs advanced, does this result in income to the client? In addition, if the costs are deemed paid by the client as they arise, then the client could may be forced to deduct them in years for which they have inadequate income to use them.
[This article originally appeared in Trial Briefs, February 2012.]