Trial Attorney Tax Summary for Taxation of Settlements and Damages – Part 5: Assignment of Claims

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Overview

Part 4 of this series focuses on the payment of damages for false imprisonment. This installment will focus on the assignment of claims. When it becomes apparent that a settlement from the defendant might be in the making, plaintiff’s frequently become more interested in the tax consequences of the settlement.

The stakes have gotten even higher tax reform at the end of 2012. As we have indicated so far, most categories of damages are taxable as ordinary income except for damages on account of physical injury or physical sickness under IRC Sec 104(a)(2). Even when the when the damages are non-taxable for income tax purposes, the award can still have federal estate tax consequences. When you consider the impact of both layers of taxation (income and estate tax), the combined impact can erode 70-80 percent of the settlement or damages award.

The top marginal bracket for taxpayers with more than $400,000 (single and $450,000 married) increased to 39.6 percent. Taxpayers with adjusted gross income in excess of $250,000 will pick up an additional 3.8 percent on unearned income raising the top marginal bracket to 43.4 percent. These same taxpayers will also be exposed to the phase out of personal exemptions and miscellaneous deductions.

These phase outs effectively raise the marginal bracket by 1-2 percent. Taxpayers in the top marginal bracket will end up with a top federal bracket of 45.4 percent. High income states such as New York and California add an additional 8-10 percent bringing taxpayers to a combined marginal tax bracket of 53-56 percent.

This article is designed to outline the tax consequences of the plaintiff’s assignment of a claim as well as some of the tax planning possibilities for the plaintiff and his family.

Tax Consequences in the Assignment of Claims

The principal tax issue involved in the assignment of a claim is the anticipatory assignment of income doctrine. Under the assignment of income doctrine, a taxpayer who earns or otherwise creates the right to income, will be taxed on any gain realized from it. If the taxpayer has the right to receive the income and the income is almost certain to be paid, it is too late to avoid the income.

The case law involving the assignment of income generally hold that once payment becomes certain, the taxpayer (transferor) is taxable on the income rather than the transferee. However, if the income or claim is doubtful or contingent, the transferee is taxable on the income

As a result, it is possible to transfer a claim before it ripens. Several claims and rulings provide a successful road map for  the transfer of a claim. In Cold Water Process v. Commissioner, 247 F2d 864 (6th Cir 1957) reviewing 25 T.C. 1333 (1956), the 6th Circuit Court of Appeals held that the taxpayer’s right to income is not earned and does not ripen until all appeals on the judgment have been exhausted.

In PLR 200534015 the taxpayer successfully transferred the right to a wrongful death claim to an irrevocable trust. The ruling focused on the gift tax aspects on the transfer but not the valuation of the transfer. The ruling noted that the right to the claim was a valid property right under state property law and could be equitably assigned by the taxpayer.

In PLR  200107019 ruled favorably on the taxpayer’s assignment of a claim for punitive damages to a charitable trust while the settlement was still inchoate or unsettled. When recovery is uncertain or contingent at the time of the transfer, the taxpayer is not required to pick up the income.

In Schulze v. Commissioner, T.C. Memo 1983-263, the Tax Court ruled favorably on the assignment of a claim because at the time of the transfer the result of arbitration was uncertain. Additionally, the arbitration wasn’t completed for an additional year. The transfer also had a legitimate planning purpose other than the avoidance of taxes.

More recently, in PLR 20123202, the Service ruled favorably citing the cas law mentioned above and reinforcing the idea that the assignment of a claim is not taxable until its payment become certain. In the case of a litigation claim, this means that the payment is not certain until all appeals have been exhausted.

Can the Attorney Assign His Compensation?

The Planning Possibilities of Assigning a Claim

The ability of assigning while it is inchoate offers a multitude of planning possibilities. From an income tax standpoint, the claim might be transferred to a structure that offers income tax deferral and future estate tax savings.

  1. Roth IRA

The trustee of a self-directed Roth IRA could purchase the claim from the taxpayer on an arms-length basis. In the event the claim becomes payable, the income will not be taxable to the taxpayer nor should the character be considered unrelated business taxable income. The claims proceeds can be reinvested within the self-directed IRA without taxation of the investment earnings. The taxpayer has the ability take distributions from the Roth IRA on or after the taxpayer reaches age 59 1/5 or five years after the contribution. Importantly, the younger taxpayer can take early distributions on a tax-free basis by relying on the exception under IRC Sec 72(t) for substantially equal and periodic payments. The only disadvantage of the Roth IRA is the possible inclusion of the Roth IRA account if the taxpayer has a taxable estate. Recent tax law left the exemption equivalent at $5.25 million for the taxpayer.

  1. Family Investment Company (aka Charitable LLC)

Summary

Personally I can’t imagine many things worse than being incarcerated for a crime that you did not commit. In the era of high tech forensic science, this has become a common occurrence.  A number of states have adopted legislation providing compensation for false imprisonment. Adverse tax treatment on the settlement can add insult to injury by treating the settlement damages treated as taxable income. As a matter of policy, it would seem that the least we should be able to do for someone who was falsely incarcerated is to allow them to receive tax-free treatment on any compensation received.