Opinion/confirmation question - odd situation

[Judge Roy Bean]

As regulars 'round these parts know, I see tax law issues as bad juju magic. But the day and hour invites "not legal or tax advice" from this august body to balance against what is probably going to come to a family acquaintance at considerable expense later next week.

Party "A" (our family's friend) was sued by "B" in a state court on defamation grounds. Property owner "B" was basically retaliating for "A"'s trying to rally local property-owner support to enforce extant state and county ordinances regarding what can be done to an acreage.

"A" had an umbrella insurance policy and his insurer engaged a local firm to defend the defamation claim. "A" determined the counsel to be somewhat less than qualified and on her own dime retained another firm she had used over the years. The two firms worked together.

Given "B"'s inordinately deep pockets and belligerence, the case progresses well into a complex discovery process involving multiple experts who will posit that the defamation claim is absurd - the facts of what was allegedly said by "A" about what was being done to the acreage are indisputable thereby blocking any claim.

The privately retained counsel for "A" smelled blood, including malicious abuse of process (common law state). "B" has to be into this close to six figures and apparently doesn't care - they are seemingly willing to drag this on into infinity in the hopes that "A" will run out of money and settle. Counsel for the insurer - naturally - wants to get out as quickly as possible.

Now, the adjuster for the insurance carrier, after expending well into five figures, is offering to hand "A" a large chunk of money to just go away and let the privately-retained counsel pursue the case.

But if the carrier hands "A" a six-figure amount before the end of this year to walk away and indemnify themselves from any further liability, what is "A"'s personal tax liability for that amount in 2009? As of yesterday, the insurer isn't providing tax advice and given the amount involved I felt it best to seek multiple "opinions."

[Nikki]

The facts do not seem to suggest that the $nnn,000 will qualify for any kind of exclusion from taxable income.

In addition, A's expenditures (which indirectly resulted in the $$$$$) don't appear to qualify as any type of legitimate deduction.

My best guess -- absent some serious financial planning prior to the delivery of the check -- current income taxed at the highest rate ALSO impacting current exemptions and deductions due to alternative minimum tax and various phase-outs.

[jg]

Based on the general information in this case the proceeds of the settlement are included in income in full (even if a portion is paid to the attorney for A) since there is no physical injury.
Since the legal fees seem not to be for the production or protection of income there is not any deduction for these personal legal fees.

Given that the income will be included in the year received (or able to be received) and the ordinary marginal rate will apply you may wish to consider grossing up the award to cover the individual income taxes payable for both federal and state taxes.

I hope this helps to confirm your understanding of the general rules even though all of the facts and circumstances should be discussed with an experienced practitioner to get the correct application of the rules to the particular case.

Best wishes.

[jcolvin2]

Based on the general information in this case the proceeds of the settlement are included in income in full (even if a portion is paid to the attorney for A) since there is no physical injury.

A is not the party claiming the injury. Even if B had filed a lawsuit claiming damages for physical injury or sickness, A would not be able to exclude the funds under section 104.

Insurance payments can be excluded to the extent that they don't exceed basis. Accordingly, if A is out of pocket to his personal attorney, he may have some basis, and be able to exclude a portion of the funds.

Since the insurance payment - if made to B rather than to A - would not be taxable, perhaps there is an argument for open transaction treatment. This would entail waiting to determine the liability of A to B, and then netting the payment from the insurer against that. If the payment from the insurer exceeded what was ultimately determined to be the liability from A to B, then A would have income measured by the difference between what he received from the insurer and what he paid to B.

One additional thought: if the amount is included in income this year, and later A settles with B and pays over some or all of what was received by A from the insurer, it may be possible to use the "claim of right" provisions of section 1341 in the year of payment to reduce taxes in that year. (The inclusion in income in the current year of an item that turns out not to be income can be a deduction - or otherwise generate a refund - in the year that the item is returned/repaid.)

[Judge Roy Bean]

Thanks. I have passed that on.

[LaVidaRoja]

IF the amount involved is sufficiently signifcant, request a Private Letter Ruling