Tax News
A Multimillion Dollar Settlement Allocation Slap on the Wrist
October 06, 2011
Investment funds litigate and settle cases like many other taxpayers. The settlement process is usually handled by litigators, in-house or otherwise. Some litigators are attuned and aware of the tax issues related to settlements and others are not. As it may be the case, settlements have significant tax consequences, and as the recent decision of Healthpoint v. Commissioner, T.C. Memo. 2011-241 (October 3, 2011) demonstrates, could lead to further tax related litigation and penalties. What’s usually at stake? The two key tax elements of a tax settlement are character of income inclusion (ordinary v. capital) and deductibility of the settlement payment and related expenses. Most settlements take place after the filing of a complaint and sometimes even the conclusion of a trial. Hence, the settlement supervenes some well documented manifestation of the parties’ claims, which often are numerous and based on various litigation theories. The nature of these claims is the most determinative factor of the ultimate tax consequences of the settlement. 

Many sophisticated taxpayers who are aware of the tax implications of settlements specifically allocate the settlement proceeds between the different legal claims. Typically this is done directly in the settlement agreement. It is not unusual for taxpayers to attempt to allocate the proceeds in the most tax advantageous way. Unfortunately, however, what some taxpayers may not know is that the contractual allocation stipulated in the settlement documents is not binding on the IRS. The Healthpoint case offers a great illustration of the detrimental consequences that can ensue when the taxpayer deviates from the legal claims averred in the litigation and from the allocation produced by the jury. In this case a jury had stipulated prior to the settlement that damages should be allocated among actual damages, lost profits, punitive damages and Lanham Act enhanced damages. The taxpayer chose to allocate settlement proceeds to only two categories of claims, goodwill/reputation and lost profits, thus, completely disregarding punitive damages, an allocation to which would have been taxable as ordinary income. The Tax Court disagreed with this allocation saying that judicial approbation of express settlement allocations for Federal income tax purposes is not warranted where circumstantial factors reveal that the designation of the settlement proceeds was not the result of adversarial, arm’s-length and good faith negotiations and is incongruous with the “economic realities” of the taxpayer’s underlying claims. Under the particular circumstances, the best representation of the proper allocation was the jury verdict, the Tax Court reasoned. In ruling against the taxpayer, the court further imposed accuracy related penalties. Healthpoint attempted to defend based on reasonable cause. However, the tax counsel Healthpoint relied on at the time of the settlement did not provide an opinion as to the propriety of the allocations and did not participate in the negotiations regarding the total amount of the settlement or the amount of each individual allocation.

So what’s the moral of the story here? Taking into account tax considerations when allocating settlement proceeds is a normal business practice that would likely not change.  However, taxpayers are put on notice that drastically departing from the claims in the litigation related documents could invoke the scrutiny of the IRS and the disagreement of the Tax Court. This apparently can happen regardless of the fact that the settlement is between unrelated parties and negotiated in an adversarial environment. Taxpayers engaged in settlement allocations are well advised to seek competent tax counsel and to painstakingly document the advice and counsel’s participation in the negotiations.
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Tags: Healthpoint v. Commissioner, section 6662, section 6664, settlements