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Holliday v. Commissioner (T.C. Memo. 2021-69)

On June 7, 2021, the Tax Court issued a Memorandum Opinion in the case of Holliday v. Commissioner (T.C. Memo. 2021-69). The primary issue presented in Holliday was whether settlement proceeds petitioner received in 2014 constitute taxable income.

Background

Two lawsuits are central to this case. The first is petitioner’s divorce proceeding, in which she was represented by J. Beverly and his law firm (divorce attorney and malpractice defendants, respectively). The second is petitioner’s malpractice lawsuit against her divorce attorney, in which she was represented by Lance Kassab (malpractice attorney).

In March 2010, the petitioner’s former spouse filed for divorce. As part of the divorce proceedings, the petitioner and her divorce attorney participated in mediation. It resulted in petitioner’s executing a mediated settlement agreement. Petitioner objected to the mediated settlement agreement, but her objections were not sustained by the divorce court. In April 2012, the divorce court entered the Agreed Final Decree of Divorce between petitioner and her former spouse. In May 2012 petitioner’s divorce attorney filed a motion for a new trial and stated that petitioner received $74,864 less than her equal share of the community estate. The motion for a new trial was denied. Petitioner’s divorce attorney told petitioner he would appeal, but he failed to do so.

In October 2013 petitioner filed a malpractice lawsuit against her divorce attorney, claiming gross negligence and that he breached the duty of fair dealing and his fiduciary duties for pressuring her to mediate and for failing to appeal the motion for new trial.  She sought damages for “pecuniary and compensatory losses”, including “damages for past and future mental anguish, suffering, stress, anxiety, humiliation, and loss of ability to enjoy life”, as well as punitive damages and disgorgement of the attorney’s fees she paid in the divorce proceeding, resulting from the malpractice defendants’ conduct.

In October 2014, the petitioner and the malpractice defendants entered into a settlement agreement. It recited that “while there remain significant disagreements as to the merit of the claims and allegations asserted by the Parties to this lawsuit, the Parties have agreed to compromise and settle such claims and allegations, without any admission of fault or liability on the part of any party.” Under the section “Consideration,” the malpractice defendants agreed to pay petitioner $175,000 “[i]n consideration for the mutual promises and obligations set forth in this Release.” The malpractice defendants did not admit liability or fault in the settlement agreement, and the parties did not allocate any of the settlement proceeds toward any particular claim or type of damages. Petitioner received the settlement proceeds of $175,000, from which she paid her malpractice attorney’s $73,500 fee; this was effected by the malpractice attorney’s receiving the settlement check, deducting his fee, and transferring the remaining $101,500 to petitioner.

Petitioner’s Tax Return and Respondent’s Notice of Deficiency

On her 2014 Form 1040, U.S. Individual Income Tax Return, line 21, petitioner reported “[o]ther income” of zero. She acknowledged the receipt of $101,500 through an attached Form 1099-MISC Summary and a “Line 21 Statement” on which she reported “Other Income from Box 3 of 1099-Misc” of $101,500. But the Line 21 Statement then subtracts $101,500 with the description “Misclassification of Lawsuit recovery of marital assets”, resulting in total other income of zero.

In the notice of deficiency, the IRS determined that the petitioner failed to include gross income of $101,500 on the basis of the Form 1099-MISC, Miscellaneous Income, issued by her malpractice attorney. After reviewing the settlement agreement in preparation for trial of this case, the IRS amended its answer, stating that all $175,000 of the settlement proceeds should have been reported on petitioner’s 2014 Form 1040 with a corresponding miscellaneous itemized deduction of $73,500 for the payment to her malpractice attorney. This amendment resulted in the increased deficiency of $44,939.

Settlement Proceeds: Taxable Income or Nontaxable Recovery of Capital

IRC § 61(a) defines gross income as “all income from whatever source derived” and broadly encompasses any accession to a taxpayer’s wealth. Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429-430 (1955). Consistent with the broad definition is the corollary that “exclusions from income must be narrowly construed.” Commissioner v. Schleier, 515 U.S. 323, 328 (1995) (quoting United States v. Burke, 504 U.S. 229, 248 (1992)); see Wesson v. United States, 48 F.3d 894, 898 (5th Cir. 1995). And “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.” Commissioner v. Banks, 543 U.S. 426, 430 (2005). Generally, however, the recovery of capital is not income. See United States v. Safety Car Heating & Lighting Co., 297 U.S. 88, 98 (1936); Milenbach v. Commissioner, 318 F.3d at 933 (noting that proceeds that represent compensation for lost value or capital generally are not taxable); Freeman v. Commissioner, 33 T.C. 323, 327 [*9] (1959) (noting that proceeds received “as the replacement of capital destroyed or injured rather than for lost profits” are a return of capital and not taxable”); see also Wesson v. United States, 48 F.3d at 899 (discussing that compensatory damages for personal injuries are excluded from gross income “because, in effect, they restore a loss to capital” (quoting Hawkins v. United States, 30 F.3d 1077, 1083 (9th Cir. 1994))).

Whether a payment received in settlement of a claim represents a recovery of capital depends on the nature of the claims that were the basis for the settlement. See Spangler v. Commissioner, 323 F.2d 913, 916 (9th Cir. 1963), aff’g T.C. Memo. 1961-341; see also Sager Glove Corp. v. Commissioner, 36 T.C. 1173, 1180 (1961) (“The taxability of the proceeds of a lawsuit, or of a sum received in settlement thereof, depends upon the nature of the claim and the actual basis of recovery.”), aff’d, 311 F.2d 210 (7th Cir. 1962). The Tax Court has held previously that “an amount paid to a taxpayer in order to compensate the taxpayer for a loss that the taxpayer suffered because of the erroneous advice of the taxpayer’s tax consultant generally is a return of capital and is not includible in the taxpayer’s income.” Cosentino v. Commissioner, T.C. Memo. 2014-186, *31; see also Clark v. Commissioner, 40 B.T.A. 333, 335 (1939); Concord Instruments Corp. v. Commissioner, T.C. Memo. 1994-248, *24-*25.

To determine whether a settlement represents lost profit or lost value, the Tax Court examines in lieu of what was the settlement awarded? Green v. Commissioner, 507 F.3d 857, 867 (5th Cir. 2007) (quoting Srivastava v. Commissioner, 220 F.3d 353, 365 (5th Cir. 2000), aff’g in part, rev’g and remanding in part T.C. Memo. 1998-362), aff’g T.C. Memo. 2005-250. This is a question of fact. Id. at 866-67. “Ultimately, the character of the payment hinges on the payor’s dominant reason for making the payment.” Id. at 868. The Tax Court first looks to the language of the agreement itself for indicia of purpose, focusing on the origin and characteristics of the claims settled in that agreement. Id. at 867 (quoting Pipitone v. United States, 180 F.3d 859, 862 (7th Cir. 1999)). Where the agreement does not mention purpose, the Tax Court may look at other facts that reveal the payor’s intent, such as amount paid, evidence adduced at trial, and the factual circumstances that led to the agreement. Id. at 867-868; see also Robinson v. Commissioner, 102 T.C. 116, 126 (1994) (noting that the determination of the nature of the claims settled “is generally made by reference to the settlement agreement in light of the surrounding circumstances”), aff’d in part, rev’d in part, and remanded on another issue, 70 F.3d 34 (5th Cir. 1995).

The Petitioner’s (Unavailing) Argument

The petitioner argues that the settlement proceeds are only for those claims that involve the marital estate and that they represent compensation for lost value or capital because they are based on her recovery of the property interest that she rightfully should have received from her divorce as her share of the marital estate. However, the settlement agreement says that the settlement proceeds are for the release of all claims of whatever kind or character, known or unknown which the petitioner may have against her divorce attorneys arising out of or related to the malpractice lawsuit.

The petitioner thus asks the Tax Court to look through the settlement agreement and consider only her claims related to recovery of marital property. The Tax Court politely declined to look “beyond the plain terms of the settlement agreement,” and it instead concluded that the settlement proceeds were to compensate her for her attorney’s malpractice and, therefore, are taxable.  The Tax Court observes that it recently rejected a similar attempt to recharacterize the settlement of a legal malpractice claim arising from a personal injury lawsuit in Blum v. Commissioner, T.C. Memo. 2021-18.

The Tax Court’s Holding

The Tax Court found that the petitioner “failed to convince us” that the settlement proceeds were meant only to replace her marital property, rather than generally to release the malpractice defendants from the various claims and types of damages listed in the malpractice petition. The Tax Court, therefore, concluded that the settlement proceeds do not represent recovery of capital, and it sustained the IRS’s determination in the notice of deficiency that the settlement proceeds are includible in gross income.

(T.C. Memo. 2021-69) Holliday v. Commissioner

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