As a business advisor and tax attorney representing businesses, we inevitably run into circumstances where we are advising businesses on disputes with third parties. Although we do our best to minimize disruption within the business—to ensure that we maximize profits—disputes will arise. And, in some instances, those disputes require us to pursue court intervention, mediation, or arbitration. Thus, during the normal course of any business operation, a business may find itself the recipient or payer in a settlement or judgment as a result of that court intervention, mediation, or arbitration.
Unfortunately, the federal tax implications of that settlement or judgment are often overlooked by the business owner/executive and the litigation/controversy attorney handling that dispute. The business generally just wants its pound of flesh, and the attorney usually just wants to “win.” But, what does all of that really mean? For both the payer and the recipient, the terms of a settlement or judgment may affect whether a payment is deductible or nondeductible, taxable or nontaxable, and its character—i.e., capital or ordinary—all of which may impact the perception of whether or not the settlement or judgement was a “win.” That perception and determination will likely come down to an analysis related to the “origin of the claim.”
Origin of the Claim
Under the origin of the claim doctrine, the tax consequences of settlement proceeds are determined by the nature of the claim and the actual basis of recovery. According to the U.S. Supreme Court, courts must ask: In lieu of, what were the damages awarded? That is the U.S. Supreme Court’s mandated concept of the origin of the claim analysis. In United States v. Gilmore, the Court used this analysis to distinguish between deductible and nondeductible litigation expenses. Since Gilmore, courts have utilized the doctrine to determine whether proceeds from a lawsuit or settlement are taxable as ordinary income or as capital gain. As an example, an award for lost profits may be taxable as ordinary income, while an award for damage to an asset may be considered a return of capital to the extent of the basis in the asset, with the excess amount over basis treated as gain. Again, what is the origin of the claim?
Considerations Regarding Each Dispute
When we consult with business owners and executives on a potential dispute, we ask them to take into consideration a number of thoughts, including:
- What is the big picture here, recognizing that your decision today will ultimately determine your final destination, both personally and for the business?
- What may be the unintended consequences of that decision and resolution of that dispute?
- What will the cost be, both from an actual dollar amount, that of a relationship, as well as the potential of opportunity cost?
- What are the hazards of that dispute and chances of success?
- Is this all about principle?
- What is the likely outcome, in terms of the settlement or judgment, including the terms?
- And, how can we ensure that the final outcome is structured in the most tax-efficient manner?
Conclusion
In sum, there is a lot to consider in every dispute. Taxes are only one aspect of that dispute, although many times overlooked. The time to consider the tax consequences, as well as all other consequences, is before the dispute arises through court intervention, mediation, or arbitration. That is, waiting until the final determination of that dispute to consider the tax consequences will be too late. The ground work for the “origin of the claim” analysis will have already been decided. Therefore, while tax consequences may not be the final determining factor of whether a dispute should be pursued, it should be one of the factors considered, before you decide to pursue that dispute.
Comments