Sometimes, losing plaintiffs think their attorney messed up. Sometimes, they are so sure that they sue their attorney for legal malpractice. I think of those as lawsuits-within-lawsuits, kind of like the story-within-a-story literary device, perhaps most famously used by Shakespeare in Hamlet. In a malpractice action, the original lawsuit becomes a lawsuit-within-a-lawsuit because the court decides the malpractice action in part by making a counterfactual inquiry on what could have been the outcome in the original lawsuit.
Sometimes, plaintiffs actually win the malpractice action. More often they settle, accepting some amount of money from the attorney (or, more often, the attorney’s insurer) in exchange for promising to go away and never come back.
The extent to which an attorney malpractice settlement constitutes gross income is the ostensible lesson in two recent cases. In Carol E. Holliday v. Commissioner, T.C. Memo. 2021-69 (June 7, 2021) (Judge Pugh), and in Debra Jean Blum v. Commissioner, T.C. Memo. 2021-18 (Feb. 18, 2021) (Judge Urda), the Tax Court rejected both taxpayers’ attempt to exclude settlements of their attorney malpractice claims from gross income, even though both taxpayers may well have been able to exclude settlements of the original action. Using an “in lieu of” test, the Tax Court said that the settlement of the malpractice claim was different than settlement of the original claim. The original claim had become merely a lawsuit-within-a-lawsuit, a play-within-a-play, and thus had an insufficient nexus with the actual payment to support exclusion.
The less obvious lesson in these cases is how the ostensible lesson creates a bargaining chip for malpractice attorneys sitting at the poker table of settlement negotiations. Taxpayers might account for the tax treatment of malpractice settlements either by structuring the settlement to make the payments eligible for exclusion, or by grossing up the settlement to reflect taxes imposed that would not have been imposed on settlement of the original action. Details below the fold.
Law: The “In Lieu Of” Test For Exclusion of Lawsuit Awards
When I teach taxation of awards (or settlements) from lawsuits, I tell my students to always, always, always recognize that any such award or settlement is presumptively gross income captured by §61. That is because it will always appear to meet the famous definition of gross income as “accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” Commissioner v Glenshaw Glass Co., 348 U.S. 426, 431 (1955). Glenshaw was itself about inclusion of a punitive damage lawsuit award. The Court said that “[t]he mere fact that the payments were extracted from the wrongdoers as punishment for unlawful conduct cannot detract from their character as taxable income to the recipients.” Id.
Thus, the analysis of any lawsuit award or settlement starts by recognizing that the money is presumptively gross income. The next step, however, is to look for a good reason to exclude. As always, it’s up to the taxpayer to prove an entitlement to an exclusion. Exclusion might be justified either because of common law or because of a statute. Today’s lesson involves both.
First, the common law of tax says that if the award is merely a return of lost capital, then it’s not an accession to wealth at all, and does not constitute gross income. I call this the common law of tax because it is basically part of how courts define the concept of gross income. The classic case is Raytheon Production Co. v. Commissioner, 144 F.2d 110 (1st Cir. 1944). There, the plaintiff sued for tortuous interference in its business of producing radio tubes, with the claim being that the defendant’s actions totally destroyed its business to the tune of $3 million in damages. The parties settled for $410,000.
To decide whether any part of the $410,000 was gross income, the Raytheon court looked at what were the damages being paid to compensate for. The Raytheon court explained: “The test is not whether the action was one in tort or contract but rather the question to be asked is ‘In lieu of what were the damages awarded?’" Id. at 113. Courts applying this test largely look at the plaintiff’s claim to decide what the damages are in lieu of. Thus, sometimes you will hear this test called the “origin of the claim” test. Heck, I do that as well. However, that is not entirely accurate because, as we'll shortly see, courts look at the entire course of the litigation, including settlement negotiations and the terms of any settlement agreement as well as the formal allegations contained in the pleadings.
Applying the "in lieu of" test, the Raytheon court found that the plaintiff was not trying to recover lost profits but was seeking to recover damages to its business and associated goodwill, a capital asset. So a recovery would be a return of capital. The court emphasized that “[w]here the suit is not to recover lost profits but is for injury to good will, the recovery represents a return of capital and, with certain limitations to be set forth below, is not taxable.” Id. at 113. The “certain limitations” were simply that dollars recovered in excess of basis in the capital asset lost (here, the goodwill) would be taxable. That’s what tripped up Raytheon. Remember I said that you always start with the presumption that the lawsuit proceeds are taxable? Well, Raytheon could not show what its basis had been in goodwill. Therefore, it could not show mow much of the $410,000 was return of basis. So it was all income. So while the taxpayer won its theory, it lost on the facts.
Second, a lawsuit award or settlement will be excluded from gross income if there is a statutory basis for exclusion. The main example here is §104(a)(2). It allows exclusion of all damages (except punitive damages) “received on account of personal physical injury or physical sickness.” As with the non-statutory basis for exclusion, courts still use the “in lieu of” test, asking what was the plaintiff seeking to recover for? Here, the requirement is that the plaintiff needed to be seeking damages “on account of personal physical injury or physical sickness.” For a good lesson on that requirement, see Lesson From The Tax Court: An 'Origin of the Claim' Test For §104(a)(2) Exclusions, TaxProf Blog (July 16, 2018).
Whether the taxpayer is claiming a common law or statutory exclusion, it bears emphasizing that courts look to more than just the Complaint to decide the proper tax treatment. Courts look at the text of the settlement as well, and take into account the arms-length nature of the agreement. They also look at more. As the Tax Court has explained, “the pertinent analysis entails a consideration of extrinsic factors informative of the nature of the underlying claims.... Relevant extrinsic factors include the details surrounding the litigation, the allegations contained in the complaint and the course of the settlement negotiations between the parties.” Goode v. Commissioner, T.C. Memo 2006-48 (March 21, 2006).
How the settlement of a legal malpractice action relates to the “in lieu of” test is the lesson for today. Let’s take a look.
Both of our two cases today involve malpractice awards, but for two very different types of original cases.
1. Facts in Holliday
Ms. Holliday divorced her husband in 2010. They went to mediation and signed an agreement. After that, however, Ms. Holliday decided she was getting shorted some $75,000 in the division of community property. She sought to undo the agreement. She failed. Over her objections, the divorce court adopted the mediated agreement and entered it as an Agreed Final Decree. It wasn’t. Her divorce attorney appears to have then blown the deadline for taking an appeal. She sued her attorney for committing malpractice, the chief claims being that he (1) improperly influenced her to sign the agreement and (2) blew the appeal deadline. Her malpractice complaint 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.” Oh, and she threw in a claim for punitive damages as well. Oh, and she asked for a return of the attorneys fees she had paid her divorce lawyer. She did not, however, put in a claim for the kitchen sink. One wonders why.
We’ll never know the merits of Ms. Holliday’s malpractice claim. That is because the parties settled the case for $175,000. As part of the settlement the parties signed the standard all-encompassing mutual release of all claims “of whatever kind or character, known or unknown.”
Judge Pugh is careful to note that the “malpractice defendants did not admit liability or fault in the settlement agreement, and the parties did not allocate any of the settlement proceeds towards any particular claim or type of damages.” Op. at 5 (emphasis supplied).
Notice the flow of money here. The malpractice insurer sent the entire $175,000 to Ms. Holliday’s malpractice attorney. He, in turn, took out $73,500 for fees and expenses and then sent the remaining $101,500 to Ms. Holliday. It appears someone also tried to do her a “favor” by sending her a 1099-MISC reporting only the $101,500 distribution.
Now you know and I know that Ms. Holliday should have reported the entire $175,000 as income, and then reported the attorneys fees as a below-the-line miscellaneous itemized expense (the tax year was 2014, before Congress enacted evil §67(g)). But no. She got greedy. She not only failed to report the entire $175,000, she also failed to report the $101,500, claiming on her return that it was a “mis-classification of lawsuit recovery of marital assets.” Oy vey. The IRS disagreed. Ms. Holliday hired yet another attorney and petitioned Tax Court.
2. Facts of Blum
Ms. Blum filed a personal injury lawsuit after she had been injured in a hospital while waiting for knee surgery. It seems a wheelchair collapsed under her. Her original personal injury attorney retired during the course of the suit and handed the case to an associate who promptly lost a summary judgment motion. Ms. Blum then sued the law firm for legal malpractice. Her malpractice Complaint alleged that she had physical injuries caused solely by the hospital, that her personal injury attorneys breached the standard of care in handling her case, and that but for that breach, she would have won her case against the hospital. Judge Urda is careful to note that nowhere did Ms. Blum “allege in her complaint that she had suffered any physical injuries for which her former attorneys should be responsible, nor did she seek compensation for any physical injuries.” Op. at 4.
Like Ms. Holliday, Ms. Blum decided she did not need to report any of the $125,000 settlement proceeds. She at least received a proper 1099, showing payment to her of the entire $125,000.
Lesson 1: Malpractice Settlements Are For Different Injury Than Underlying Claim
Both Ms. Holliday and Ms. Blum argued that their malpractice awards were “in lieu of” the damages they would have received in the underlying action. Since those damages would have been excluded (per Raytheon for Ms. Holliday and per §104(a)(2) for Ms. Blum), the taxpayers argued that their malpractice settlements should also be excluded.
But that's not the right "in lieu of" test.
Both Judges Pugh and Urda rejected the argument and for the same reason: the excludable damages related to the lawsuit-within-the-lawsuit and not the malpractice action itself. Writes Judge Pugh: whether a settlement award is excludable “depends on the nature of the claims that were the basis for the settlement.” Holliday at p. 9. She then notes that the basis of the malpractice settlement agreement contains nothing to suggest that the settlement proceeds were meant to replace the community property Ms. Holliday did not receive. Rather, the settlement agreement’s text recited its purpose was to compromise and settle the malpractice claims and that the payment made was in exchange for release of the malpractice claims. Op. at 10-11.
Similarly, Judge Urda writes: “When damages are received pursuant to a settlement agreement, the nature of the claim that was the actual basis for the settlement controls whether the damages are excluable under section 104(a)(2).” Blum at p. 8. Just as in Holliday, the settlement document in Blum expressly identified purpose of the agreement as being to settle a legal malpractice claim. The Blum settlement agreement goes even further and recites an agreement that the claimed malpractice did not result in any physical injury to Ms. Blum! Concludes Judge Urda: “The agreement thus makes clear that the payment was in lieu of damages for legal malpractice and not on account of personal physical injuries or physical sickness within the scope of §104(a)(2).” Op. at 10.
In short, the reason the taxpayers lost here is because they were unable to link their malpractice settlement amounts to the claims contained in the lawsuit-within-the-lawsuit. The Tax Court teaches that, absent evidence otherwise, settlement proceeds in a legal malpractice lawsuit are simply not “in lieu of” the damages that would have been received in the lawsuit-within-the-lawsuit, the hypothetical outcome of the original action.
Note the emphasized caveat, because that’s the second lesson.
Lesson 2: Structure Those Settlements!
Lesson 1 is not absolute. There may be some wiggle room. The caveat gives what I think is the second lesson here. Smart malpractice attorneys (or their smart tax advisors) may sometimes have room to account for the taxation of malpractice damages in two ways.
First, every malpractice Complaint should request some quantum of damages explicitly as “in lieu of” the damages the plaintiff should have received in the original action. For example, Ms. Holliday apparently thinks she got shorted $75,000 in community property. Even if her Complaint asks for $1 million in total damages, it should break out $75,000 as being owed to her as a substitute for what she would have received, but for the alleged malpractice. Here, for example, it does appear that her Complaint asked for return of attorneys fees. That would seem a capital recovery and, hence, excludable under Raytheon. Second, every malpractice settlement agreement should contain similar language, if possible, that attributes some quantum of the settlement amount as a substitute for the damages plaintiff would have won in the action below. So of the $175,000 that Ms. Holliday received, the settlement agreement could have specifically identified $75,000 as representing the amount she would have recovered in the original lawsuit. Or she could have at least designated part of it as a return of the fees she had paid. She did neither.
Yes, I know this is easier said than done. But the very fact that malpractice defendants might resist such an attribution is all the more reason why the IRS or Tax Court will accept it: it shows arms-length bargaining. Either or both of those moves would have given Ms. Holliday or Ms. Blum a much stronger “in lieu of” argument. I’m not saying it’s a for-sure winner, just that it’s a for-sure help.
Second, the first lesson gives a good malpractice attorney another bargaining ship. They can use Holliday and Blum to create yet another quantum of damages from the malpractice: tax on the malpractice recovery! For example, Ms. Blum might say that not only did the alleged malpractice cost her a recovery of $125,000 against the hospital for the faulty wheelchair, it also cost her a tax-free $125,000. That means the settlement amount needs to be grossed up to account for the tax hit, perhaps by somewhere around $30,000 (Ms. Blum’s NOD dinged her for a tax deficiency of $27,418).
Notice that these ideas do fit together. If the malpractice defendants become aware that one item of damage is the taxes on proceeds that would have otherwise been excluded from income, then perhaps instead of a gross-up, the malpractice defendants might be more willing to agree to settlement terms that explicitly designate part of the settlement amount as a substitute for what would have been recovered in the original action.
In sum, this lesson is to see how the tax treatment of malpractice settlements creates another bargaining chip at the poker table of settlement negotiations. Yes, I said that before, but I like the image so much I wanted to repeat it. That's just the occupational hazard of being a professor.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return to TaxProf Blog each Monday for a new Lesson From The Tax Court.