Does IRS Tax Authorized Malpractice Settlements?

Illegal activity claims arise from accidents and medical misconduct, wills and trusts, divorce, litigation, tax advice, real estate deals, and many other types of legal matters. Regardless of the circumstances in which an infringement case is resolved, tax issues can arise. Is the clawback taxable, and if so, is it ordinary income, capital gain, basic clawback, or a combination thereof? There doesn’t seem to be a shortage of violations cases and reclaims, but there is little authority over how they are taxed. It can be difficult to convince the IRS and the courts not to tax payments. Here are some examples of wrongdoing recovery with comments on how it could be taxed.

Example 1. Paula Plaintiff is injured in a car accident and keeps Alan Ambulance Chaser to represent her against the driver and his insurance company. Alan cannot file a lawsuit until the statute of limitations has expired. Instead, Paula pursues him and recovers from violating the law. Paula was physically injured, but in the end Paula recovers from her lawyer, not the person who injured her. Section 104 (a) of the Tax Code excludes claims for damages from gross income that have arisen due to personal injury or physical illness. If Paula does not receive interest or punitive damages, all of her recovery should be tax free. It shouldn’t matter whether the claim to misconduct comes from tort or contractual reasons. Nor should it matter who pays Paula, the driver, the driver’s insurer, Larry, or the insurer for Larry’s misconduct. Third parties are engaged and pay (or contribute to) settlements or judgments in any number of contexts. The analysis becomes more complex when Paula reimburses punitive damages, as punitive damages are always taxable.


Example 2. Mary does a routine medical procedure, but the doctor botches it, leaving Mary physically injured and emotionally troubled. Mary goes to Larry Lawyer, who does not file a lawsuit before the statute of limitations expires. Eventually, Mary recovers from Larry for legal violations. The tax result for Mary should be the same as for Paula. The case of medical misconduct is just another type of personal injury. If Mary recovers, it could be a violation of the law, but it is actually the underlying medical malpractice. Another party pays, but that shouldn’t matter to the tax result.

Example 3. Tim and Tanya are getting divorced, and Tim’s attorney Larry assures Tim that his interest in his startup is his separate property and is safe from divorce in the event of a divorce. Instead, Tanya has half the shares in the startup. Tim sues Larry and eventually recovers. This should probably not be taxable, provided that Tim had a sufficient base in his startup portfolio to take over the accounting of Larry. In this case, similar to a case of construction defects or lost investments, Tim can potentially reduce his base by the amount of Larry’s clawback. This is better than having to take it in income.

However, if Tim has a negligible foundation – and in my experience it usually is – then the settlement money is taxable. Even if Tim has adequate base in his stocks, isn’t that a sale or an exchange? Tim started with a block of stocks and ended up with only half of it. He then receives money from his lawyer to compensate him for the stock. That sounds taxable, although Tim can claim it is capital gain. If the stock was a qualifying small business stock, could Tim argue that this was a sale? Maybe because he’s generating income, albeit from someone who really didn’t end up with the stock.

Qualified Small Business Stocks (QSBS) are still included in the Federal Tax Act. If you qualify, up to $ 10 million in sales proceeds can be tax-free when you sell your stock. The requirements are of course numerous, but it is a great benefit. Not that California tax law is out of compliance, so it is fully taxed by the Franchise Tax Board. Well, unless you leave the state before selling.

Example 4. Victor and Vera go to Larry Lawyer for estate planning. Larry prepares them and assists them in the execution of a will and trust that is later found to be flawed. As a result, their estate needs to be vetted, which costs more, takes more time, and is public. Or maybe a lack in the documents means Victor and Vera’s intended beneficiaries do not inherit and they are suing Larry. There are many variations of estate planning problems and it is difficult to list them all, let alone account for their tax treatment. Misconduct claims against estate planners often come from a beneficiary rather than the client or the client’s estate. An attorney’s mistake could result in a third party beneficiary being excluded or paying tax on an asset received from the estate. If the beneficiary is placed in the same position as they would have been without the attorney’s negligence, compensation should arguably not be income.

Example 5. Suppose Larry pollutes a real estate transaction, corporate transaction, patent application, etc.? Clive Client is suing for recovery of what it should have gotten with a knowledgeable corporate, real estate or patent attorney. This is a big topic that is difficult to summarize, and the facts are obviously going to matter. Some clawbacks of this type are ordinary income, other capital gains, and other basic repayments that could avoid current tax.

Example 6. What if Perry’s plaintiff hired Larry Lawyer to sue about something, and Perry recovered from wrongdoing without Larry Lawyers? Perry sues Larry and eventually recovers. The origin of the claims doctrine seeks to remedy this and should nevertheless do so in the case of malpractice which makes up for a legal error. However, there is no question that everything is toned down.

Despite my spitballing, it is difficult to predict the tax treatment of violations of the law. There is surprisingly little authority, so one often argues from other contexts. Not only that, but what authority there is seems to only concern tax issues, and in a way that is hardly consistent or satisfactory. In the existing agency, the IRS predictably usually argues that something is taxable. The origin of the claims doctrine should be the center of analysis for the tax treatment of misconduct recovery claims. A well-crafted complaint could help, and so do the wording of settlement agreements. However, in some cases, magical language may not be enough to change an unfortunate outcome. Taxpayers and their advisors who face significant tax problems in recovering wrongdoing should consider these problems carefully, hopefully well before it is time to sign a perjury tax return.