Litigation comes in all shapes and sizes, and there are almost always tax issues that plaintiffs, defendants, or both face. Plaintiffs who receive money worry about whether and how it is taxable and whether they can deduct their legal fees. Even without the complex rules on qualified old-age provision, the tax treatment of a legal settlement can be daunting. Suppose your employer, broker or asset manager is poorly managing your pension funds or is taking them off? They’re suing (or mediating) to get it back. If it was originally included on a tax-qualifying retirement plan, can you put it back on the plan or an IRA? Will the IRS allow this without penalizing you, or are the tax benefits gone for good after the removal?
Roth IRA versus traditional IRA written in the notepad.
And does resetting mean giving all your money back, including the part you could pay a contingent fee attorney? Or is this part taxed? You might think these questions have simple answers. But like so much in tax law, they are not that simple. Let’s start with the idea that the Internal Revenue Code’s pension rules are complex. There are extensive tax regulations for qualified pension, profit-sharing and stock bonus plans that an employer maintains for its employees. There are many tax benefits that these plans offer. The employer can write off the contributions to the plans, although it is clear that the money will stay in the plan for years and will not be taxed to the participants until later.
Income from funds held in the plan is not taxed. In addition, the participant will not be taxed on the money until they receive a distribution, usually after retirement. And since it is also about employment regulations, there are also Ministry of Labor regulations. For example, employee plan contributions must not discriminate against highly paid employees. The deductibility of employer contributions is limited. And there are restrictions on contributions and other access to plan participants’ accounts. If contributions exceed the deductible amount, the IRS will levy a 10% excise tax. There are many other technical rules.
With this complex background, if your pension is ransacked or poorly managed and you receive a severance payment, can you defer it and avoid the tax? There isn’t a lot of tax authority and it’s complex. The short answer is you may be able to put it back on the plan and avoid the tax, but you have to be careful. The IRS has tried to address some of these nuances in judgments.
In Revenue Ruling 2002-45, 2002-2 CB 116, the IRS examined whether certain payments could be treated as pension contributions and therefore not taxable. The employer in the IRS ruling invested a disproportionate amount of plan assets in a high-risk investment that later became worthless. The IRS looked at two patterns of fact. In situation 1, the plan participants sued the employer for breach of fiduciary duty in connection with the high-risk investment. The parties agreed on a court-approved settlement. The employer did not acknowledge the breach of fiduciary duty, but agreed to make a payment equal to the losses (including a reasonable adjustment to the lost profit) to the plan. The payment was distributed to the participant accounts in direct proportion to their stake in the high risk investment.
Situation 2 was similar, except that in this case the participants did not file a lawsuit against the employer. Rather, the employer learned that the participants were considering legal action. Based on the circumstances, the employer has reasonably determined that he had a reasonable liability risk for the breach of duty of loyalty. It then decided to make the payment before filing a lawsuit. In considering both situations, the Revenue Ruling 2002-45 finds that paying to a plan to compensate for losses due to market fluctuations other than a breach of fiduciary duty is a contribution that is subject to numerous limits. Conversely, a “recovery payment” is a payment to a plan to recover losses from fiduciary violations under ERISA. Amounts in excess of the losses are non-refundable. Payments that treat similarly situated plan participants differently are also non-refundable.
The IRS found that the payments made in Situation 1 and 2 were restorative payments and therefore were not taxed. And normal plan restrictions would not apply to restorative payments. How about an individual retirement account? IRS Letter Ruling 200921039 looked at some of these issues in the context of making a payment to a person’s IRA.
A 77-year-old taxpayer had Company A run an IRA. Company A discovered that one of its employees had made multiple unauthorized distributions from the taxpayer’s IRA totaling “Amount D”. Company A and the taxpayer reached an agreement, with Company A agreeing to repay amount D to the IRA. The IRS verified that Company A’s payment of Amount D to the IRA was a “restoration payment” with no contribution and reallocation restrictions.
The IRS also considered whether a reasonable amount of interest could be considered part of a restorative payment. Eventually, the IRS determined that the settlement was a restorative payment. However, the IRS ruled that the interest was not a restorative payment. Pursuant to Revenue Ruling 2002-45, payments to a defined contribution plan are treated as contributions if they are simply replenishing a participant’s account after investment losses. Conversely, payments made to recover account losses due to an act (or omission) that creates a reasonable risk of liability are recovery payments. Based on this rationale, Letter Ruling 200921039 clarified that payments to an IRA to recover losses resulting from fiduciary breach, fraud, or federal or state securities violations also constitute compensation payments.
The IRS concluded that Company A’s payment of Amount D to the IRA was a restorative payment. However, the Revenue Ruling 2002-45 limits the amount of a compensation payment to the amount of the loss caused by the breach of the fiduciary duty. Therefore, the IRS ruled that interest on Amount D would not be considered a refundable payment. Tax law is technical, pension law is even more so. So be careful, and every time you try to reclaim a qualified pension or IRA loss, get help. Sometimes a word here or there in your documents can make a huge difference.