Paul L. Caron

Monday, February 25, 2019

Lesson From The Tax Court: Drawing The Line

Tax law often involves line drawing.  Doyle v. Commissioner, T.C. Memo. 2019-8 (Feb. 6, 2019) (Judge Holmes) teaches two line-drawing lessons, one about the §104(a)(2) exclusion for payments received on account of physical injury and the other about “above-the-line” vs. “below-the-line” deductions. 

Mr. Doyle was a whistle-blower who sued his former employer after it fired him.  The parties settled the case without trial.  The former employer agreed to pay Mr. Doyle a total of $350,000 for lost wages and another $250,000 for emotional distress.  The payments were each split evenly between 2010 and 2011.  For each year the employer sent Mr. Doyle a W-2 for $175,000 and a 1099-MISC for $125,000.  In addition, Mr. Doyle paid some amount in attorneys fees.

The issue litigated in Tax Court was about the $125,000 emotional distress payments in each year.  It appears Mr. Doyle’s tax return preparer, one Herbert Hunter, took what can only be described as a bizarre reporting position.  No.  Wait.  It can also be described more kindly as “weird.”  That’s how Judge Holmes puts it.  A Judge with a less generous disposition might use the word “fraudulent.”

You be the judge.  To deal with the $125,000 payments for emotional distress, Mr. Hunter created a fake Schedule C, with a “999999” NAICS code (“unclassified establishment”).  On the 2010 Schedule C he reported the $125,000 payment, and then zeroed it out by two offsetting deductions: one for $23,584 for “legal and professional services,” and one for $101,416 for “personal injury.”  Mr. Hunter prepared the 2011 in much the same way, only then the deduction for legal fees was $33,000.  ”Weird”?  “Bizarre”?  “Fraudulent”?  Take your pick.  

By the time Mr. Doyle got to Tax Court, he at least had an attorney who understood the difference between an exclusion and a deduction.  One issue was whether the emotional distress payments were excludable under §104(a)(2).  The resolution of that issue is one of the line-drawing lessons today. 

But there was a second issue in the case, one that teaches a second line-drawing lesson. Mr. Doyle’s attorney, one Steven G. Early, seems to have totally missed the second issue, involving the proper place to deduct attorneys fees.  Judge Holmes missed that as well.  Sadly, I must confess I also missed it.  But Professor Gregg Polsky caught it (and I thank him for bringing it to my attention).  So I will pass that lesson on to you.  Keep reading. 

Lesson 1: The Causality Line

Section 104(a)(2) allows a taxpayer to exclude from gross income “the amount of any damages (other than punitive damages) received...on account of personal physical injuries or physical sickness.”  But section 104(a) flush language also gives the following limitation to the scope of the 104(a)(2) exclusion: “For purposes of paragraph (2), emotional distress shall not be treated as a physical injury or physical sickness.”

When teaching this section I always emphasize the word “any” to my students because the statutory language is much broader than the common law exclusion rule.  The common law rule allows exclusion only for damages received as compensation for amounts that would have otherwise been excluded.  So lost wages or profits could not be excluded under the common law rule, but recovery of lost capital could.  See Raytheon v. Commissioner, 144 F.2d 110 (1st Cir. 1944).  Under §102(a)(4), however, lost wages and profits can be excluded if they are part of a recovery on account of physical injury or sickness.

Causality is crucial to the §104(a)(2) exclusion.  A taxpayer must show “a direct causal link between the damages and the personal injuries or physical sickness sustained.” Lindsey v. Commissioner, 422 F.3d 684 (2005) (8th Cir. 2005).  Causality, however, is not bi-directional.  Thus, payments for emotional distress are indeed excludable under 104(a)(2) if the emotional distress is caused by (“on account of”) a physical injury or sickness.  But the statute says that emotional distress, standing alone, is not the kind of physical injury or physical sickness that can trigger the 104(a)(2) exclusion.  So the causality line does not run equally in the other direction:  if a taxpayer receives payments for a physical medical condition that is caused by (“on account of”) emotional distress, those payments do not fall within the 104(a)(2) exclusion. 

In Doyle, the causality did not run in the right direction.  There were certainly physical manifestations of emotional distress present in the facts of the case: headaches, nausea, vomiting.  These were pretty mild compared to some types of physical manifestations of emotional distress seen in other cases, such as Lindsey where Mr. Lindsey suffered from hypertension and stress-related symptoms, including periodic impotency, insomnia, fatigue, occasional indigestion, and urinary incontinence.  But the severity or mildness of the physical illness is irrelevant to the analysis.  The statute, as written, demands a causal analysis: what caused the physical sickness?

Mr. Doyle’s attorney argued that the physical sickness was “caused by the stress of his wrongful termination.”  Judge Holmes thought that was no different than saying “caused by the emotional distress of his wrongful termination.”  After all, “stress” is part of “distress.”  Judge Holmes acknowledges the chicken-and-egg problem created by the statute, but points out that the Court is not in a position to undo Congress’s decision to distinguish between emotional distress and physical illness.  Until then, taxpayers must draw the causality line in the right direction.

Lesson 2: The AGI Line

Mr. Doyle settled his lawsuit in 2010 for a total of $600,000, half to be paid in 2010 and half to be paid in 2011.  To generate this result he had to pay a lawyer.  The facts are quite unclear on how much Mr. Doyle paid his lawyer and when.  But the line drawing question is the regardless of how fee structure:  where should Mr. Doyle deduct his legal expenses, above or below the line? 

This is the most famous line in tax:  the line separating those deductions Congress allows taxpayers to take from gross income (GI) to determine adjusted gross income (AGI) and those Congress allows taxpayers to take from AGI to determine taxable income (TI). 

Section 62 tells you what deductions a taxpayer can use to reduce gross income to AGI.  Section 63 then allows taxpayers to reduce AGI to TI by either a set amount (the standard deduction) or by adding together eligible deductions that the taxpayer was not able to take from gross income because they were not listed in §62(a).  We call those “itemized deductions.”  Section 67 then divides itemized deductions into two groups: those subject to a 2% floor and those not.  Those that are subject to the 2% floor are called “miscellaneous itemized deductions.”  In a really nasty move, Congress added §67(g) in December 2017 to totally disallow miscellaneous itemized deductions for tax years 2018-2025. 

So one can toss all deductions into one of three buckets:

Bucket 1: Above-The-Line Deductions, listed in §62(a). 

Bucket 2: Itemized Deductions, taken below the line.  Those are deductions not listed in §62 but instead listed in §67(b).

Bucket 3: Miscellaneous Itemized Deductions, taken below the line, subject to a 2% floor in years a taxpayer may deduct them, but totally disallowed by §67(g) for tax years 2018-2025.

If you look at the Form 1040 for 2010---one of the years at issue in this case—you will that line 37 is the line where a taxpayer reports AGI.  For that year taxpayers accounted for their above-the-line deductions on the lines before line 37.  They would account for itemized  and miscellaneous itemized deductions on Schedule A.  One of the lines above line 37 is where taxpayers would report their net profit for loss of a business.  They would give details of income and expenses for a business on Schedule C. 

Historically, §162 permits taxpayers to deduct legal fees expended in connection with their trade or business and §62(a) provides that such expenses are taken above the line.  Commissioner v. Heininger, 320 U.S. 467 (1943).  But when the taxpayer’s trade or business consists of the performance of services as an employee and are not reimbursed by an employer, then, historically, such expenses had to go below the line.  §62(a)(1).  Moreover, such expenses get tagged as miscellaneous itemized expenses because they are not listed in §67(b).  And that means taxpayers simply cannot deduct such expenses for tax years 2018-2025. §67(g)

Historically, then, Doyle would have been able to deduct his legal expenses, but would have had to do so below the line, subject to the 2% floor.  But that changed in 2004 when Congress expanded §62(a) in the American Jobs Creation Act of 2004 to allow certain legal expenses incurred by employees to be taken above the line. 

Specifically, §62(a)(20) now allows taxpayers to take certain deductible expenses above the line when incurred “in connection with any action involving a claim of unlawful discrimination (as defined in subsection (e)).”  Section 62(e)(18), in turn, defines “unlawful discrimination” as including claims “permitted under Federal, State, or local law...(ii) regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.” (emphasis supplied).

Here, Mr. Doyle sued his former employer for breach of contract, failure to pay wages, and wrongful discharge, among other theories.  He also threw in an anti-trust claim and civil conspiracy claim.  But all the claims arose from the same nucleus of operative facts: his firing allegedly in retaliation for his raising concerns about illegal corporate behavior.  It appears that both the IRS, the taxpayer’s attorney, and the Tax Court, all operated under the historical understanding and did not account for the post-2004 changes. 

First, as to the IRS, Judge Holmes writes: “In his notice of deficiency, the Commissioner allowed both these deductions [for attorneys fees], but he moved the $23,000 deduction to the Doyles’ Schedule A.  Schedule A miscellaneous itemized deductions are allowed only to the extent they exceed two percent of adjusted gross income, see sec. 67(a).”   

Second, the Tax Court also states the law as it used to be, writing: “legal fees connected to his employee status are treated as miscellaneous itemized deductions and subject to the two percent floor of section 67(a), see sec. 62(a)(1) (trade-or-business expenses deductible against gross income only “if such trade or business does not consist of the performance of services by the taxpayer as an employee”); McKay v. Commissioner, 102 T.C. 465, 493 (1994).”   The cite to pre-2004 law is one of the giveaways.

Finally, it does not appear that either Mr. Hunter, the taxpayer's CPA and return preparer, nor Mr. Early, the taxpayer’s attorney, made any attempt to argue for an above-the-line deduction for attorneys fees.  Mr. Hunter, did attempt to deduct the legal expenses above the line but not because he knew the post-2004 rule.  He tried to put them in a fake Schedule C so as to actually avoid what he thought was still the rule, that un-reimbursed employee expenses go below the line.  As Professor Polsky pointed out to me, however, Mr. Hunter’s approach was unnecessary.  At least on the facts as presented in the opinion, it appears that Mr. Doyle should be able to deduct his legal expenses above the line for 2010 and 2011.

Professor Polsky and I contact both the IRS Office of Chief Counsel and Mr. Early about this and I have no doubt that the matter will be further investigated.  As usual, there may be facts outside the scope of the opinion that would affect the outcome of the case, but everyone involved wants to be sure that the IRS gets to the correct tax liability for Mr. Doyle.  He should not pay either too much or too little.  Mr. Doyle may be on the wrong side of the causality line for the §104(a)(2) exclusion, but at least his legal expenses should be on the right side of the AGI line!

And that’s the bottom line.

Coda 1: What would you have done?  Assume a $125k payment for emotional distress reported on a 1099-MISC and assume $23,000 in attorneys fees can be attributed to that amount.  How would you have reported it in 2010?  Personally, if I was going to take the position to exclude the entirety of the payment, I would have simply not reported the $125k anywhere on the return and I would have attached a cover letter disclosing the position.  But I would have, actually, reported $102k on Line 21.  I still would have disclosed.  One advantage of disclosing a position is that you know the computer matching program will likely tag a return with that kind of discrepancy.  So you could wait for the CP2000 letter in a couple of years, or you could just explain the position so an actual IRS human employee can make the decision to toss the return out of the examination batch.  Another advantage of disclosing a position is that disclosure allows you to avoid the return preparer penalty if the position you take has a "reasonable basis." §6694(a).  If you do not disclose the position then you need "substantial authority" to avoid the §6694 penalty.  I personally do not see how Mr. Hunter even had a reasonable basis for excluding the emotional distress payments.  But I would be curious if others disagree, and why.  It also may be that Mr. Hunter did disclose his position.  If he did, however, it is not given as part of the facts of the case.

Coda 2: The AGI line did not always exist.  When you look at any return before 1944 you will not see the line!  You can check it out on the Service's really cool archive of Forms.  Here’s the 1913 Form 1040.  Here’s the 1944 Form 1040, the first year the AGI line appears.  On the 1944 through 1953 the AGI line appeared as line 1 on the “Tax Computation” page of the Form 1040.  Now here's the 1954 1040.  Starting in 1954, the AGI line appears where most of us are used to it appearing.   Actually, it looks a lot like the 2018 return’s organization.  For 1955, the AGI line appeared on line 6.  As Congress slowly added more and more non-business above-the-line deductions, the AGI line got pushed down lower and lower on the Form 1040 so by 2010 it appeared on line 34 because almost all the above-the-line deductions were listed in the lines just above it.  For 2018, the AGI is on line 7.  Taxpayers now report all their above-the-line deductions on Schedule 1.  They report itemized deductions on Schedule A.  But there is no place to report miscellaneous itemized deductions since Congress nuked ‘em.

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.

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No, I think Hunter was boxed in by the literal terms of the settlement agreement, and should not have taken these reporting positions.

Posted by: Russ Willis | Feb 26, 2019 10:33:54 AM

@Russ: I don't think anyone is blaming Mr. Doyle. And everyone commits errors, sometimes egregious errors, b/c they just don't think matters through. To me, the interesting question is how to report the settlement payments. Would you have taken the same reporting approach as Mr. Hunter took? Or would you have done it differently?

Posted by: bryan | Feb 26, 2019 5:37:09 AM

Reporting on schedule C, etc., was the preparer's workaround, and I do not think the taxpayer should be blamed. As it happens, there was some evidence, or at least allegation, of physical consequences to the emotional distress. Who dropped the ball here was the lawyer who negotiated the settlement, who failed to allocate damages to physical consequences.

Posted by: Russ Willis | Feb 25, 2019 6:56:28 PM