While we’ve all heard the quip that the proper answer to any tax question is “it depends,” that is especially true when legal settlements and awards are involved.  In the case of Holliday v. Commissioner[1] the question was whether the amount Ms. Holliday received from an action against the attorney that represented her during her divorce was a nontaxable recovery of capital or a taxable award to her.

Ms. Holliday’s Divorce

The court outlined the following facts related to Ms. Holliday’s divorce:

In March 2010 petitioner’s former spouse filed for divorce. As part of the divorce proceedings, petitioner and her divorce attorney participated in mediation.

It resulted in petitioner’s executing a mediated settlement agreement. Petitioner objected to the mediated settlement agreement, but her objections were not sustained by the divorce court.

In April 2012 the divorce court entered the Agreed Final Decree of Divorce between petitioner and her former spouse.

In May 2012 petitioner’s divorce attorney filed a motion for a new trial and stated that petitioner received $74,864 less than her equal share of the community estate. The motion for a new trial was denied. Petitioner’s divorce attorney told petitioner he would appeal, but he failed to do so.[2]

Action Against the Attorney

Ms. Holliday was not happy with this result and believed the attorney had failed to properly handle her case.  She filed a malpractice case against the attorney in October of 2013:

She claimed that her divorce attorney’s representation constituted negligence and gross negligence and that he breached the duty of fair dealing and his fiduciary duties “by influencing * * * [her] to mediate and enter into a transaction that was not fair to * * * [her] under the circumstances” and by not pursuing an appeal. She later amended the malpractice petition in July and August 2014 to add claims for deceptive trade practices, treble damages, and attorney’s fees.[3]

The Court continues, outlining what Ms. Holliday alleged were facts demonstrating the deficient nature of the attorney’s representation:

To support her claims, petitioner included facts in the malpractice petition about her former spouse’s retirement plan, the divorce attorney’s alleged failures, [*4] and her stressful experience during the mediation and other parts of the divorce litigation. Her August 2014 amendment to the malpractice petition added facts to support her deceptive trade practices claim, including that her divorce attorney failed to properly plead claims related to her former spouse’s fraud on the marital estate.

She 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”, as well as punitive damages and disgorgement of the attorney’s fees she paid in the divorce proceeding, resulting from the malpractice defendants’ conduct.[4]

The Settlement

The malpractice claim was settled by the parties without the matter going to court.  The opinion describes the settlement as follows:

In October 2014 petitioner and the malpractice defendants entered into a settlement agreement. It recited that “while there remain significant disagreements as to the merit of the claims and allegations asserted by the Parties to this lawsuit, the Parties have agreed to compromise and settle such claims and allegations, without any admission of fault or liability on the part of any party.” Under the section “Consideration”, the malpractice defendants agreed to pay petitioner $175,000 “[i]n consideration for the mutual promises and obligations set forth in this Release”. Under the section “Release”, the parties released each other from all claims related to the malpractice lawsuit “in exchange for the * * * [settlement proceeds]”. All claims included those “of whatever kind or character, known or unknown * * * which * * * [petitioner] may have against * * * [malpractice defendants] arising out of or related to the * * * [malpractice lawsuit].”  The malpractice defendants did not admit liability or fault in the settlement agreement, and the parties did not allocate any of the settlement proceeds toward any particular claim or type of damages.[5]

The broad swath of potential claims alleged and wide breadth of “known and unknown” claims covered by the settlement are fairly standard in such cases.  The plaintiff’s counsel wishes to be sure all potential avenues for recovery of damages are raised just in case the trial court might find any of those matters a basis upon which to base an award.  As well, the defendant clearly wants a settlement to be the end of the process, so in exchange for settling the matter out of court (saving the parties significant expense that would be incurred by going to trial), the defendant’s counsel will demand that the payment cover all issues without exception, rather than being limited to specific issues.

In this case the amount of the settlement is outlined as follows:

Petitioner received the settlement proceeds of $175,000, from which she paid her malpractice attorney's $73,500 fee; this was effected by the malpractice attorney's receiving the settlement check, deducting his fee, and transferring the remaining $101,500 to petitioner.[6]

The attorney representing Ms. Holliday issued her a Form 1099-MISC in the amount of $101,500, the proceeds reduced by the fee the attorney retained.

Ms. Holliday’s Tax Reporting

While Ms. Holliday did include the $101,500 on a Form 1099-MISC summary and Line 21 statement, she also had a negative entry on the schedule labeled “Misclassification of Lawsuit recovery of marital assets” that resulted in removing the $101,500 from her return.  As the label makes clear, Ms. Holliday’s position is that the amount she received merely provided her with reimbursement for the amount of property settlement she failed to receive in her divorce due to the attorney’s conduct.

The IRS noticed that Ms. Holliday had not included the $101,500 in her income, issuing a notice of deficiency for that amount.  Ms. Holliday decided to take the matter to Tax Court, at which point the IRS noticed a separate issue:

After reviewing the settlement agreement in preparation for trial of this case, respondent amended his answer, stating that all $175,000 of the settlement proceeds should have been reported on petitioner’s 2014 Form 1040 with a corresponding miscellaneous itemized deduction of $73,500 for the payment to her malpractice attorney. This amendment resulted in the increased deficiency of $44,939.[7]

The Court’s Analysis and Decision

The Tax Court noted that a recovery of capital is generally not part of income, as it just makes the recipient whole for damages incurred:

Generally, recovery of capital is not income. See United States v. Safety Car Heating & Lighting Co., 297 U.S. 88, 98 (1936); Milenbach v. Commissioner, 318 F.3d at 933 (noting that proceeds that represent compensation for lost value or capital generally are not taxable); Freeman v. Commissioner, 33 T.C. 323, 327 (1959) (noting that proceeds received “as the replacement of capital destroyed or injured rather than for lost profits” are a return of capital and not taxable”); see also Wesson v. United States, 48 F.3d at 899 (discussing that compensatory damages for personal injuries are excluded from gross income “because, in effect, they restore a loss to capital” (emphasis omitted) (quoting Hawkins v. United States, 30 F.3d 1077, 1083 (9th Cir. 1994))).[8]

But was this payment truly a recovery of capital?  The Court outlines how the issue is approached when considering the nature of a legal settlement:

Whether a payment received in settlement of a claim represents a recovery of capital depends on the nature of the claims that were the basis for the settlement. See Spangler v. Commissioner, 323 F.2d 913, 916 (9th Cir. 1963), aff’g T.C. Memo. 1961-341; see also Sager Glove Corp. v. Commissioner, 36 T.C. 1173, 1180 (1961) (“The taxability of the proceeds of a lawsuit, or of a sum received in settlement thereof, depends upon the nature of the claim and the actual basis of recovery.”), aff’d, 311 F.2d 210 (7th Cir. 1962). We have held previously that “an amount paid to a taxpayer in order to compensate the taxpayer for a loss that the taxpayer suffered because of the erroneous advice of the taxpayer’s tax consultant generally is a return of capital and is not includible in the taxpayer’s income.” Cosentino v. Commissioner, T.C. Memo. 2014-186, at *31; see also Clark v. Commissioner, 40 B.T.A. 333, 335 (1939); Concord Instruments Corp. v. Commissioner, T.C. Memo. 1994-248, 1994 WL 232364, at *24-*25.

To determine whether a settlement represents lost profit or lost value, we ask: “[I]n lieu of what was the . . . settlement awarded?” Green v. Commissioner, 507 F.3d 857, 867 (5th Cir. 2007) (quoting Srivastava v. Commissioner, 220 F.3d 353, 365 (5th Cir. 2000), aff’g in part, rev’g and remanding in part T.C. Memo. 1998-362), aff’g T.C. Memo. 2005-250. This is a question of fact. Id. at 866-867. “Ultimately, the character of the payment hinges on the payor’s dominant reason for making the payment.” Id. at 868. “We first look to the language of the agreement itself for indicia of purpose”, focusing on “the origin and characteristics of the claims settled * * * [in that agreement]”. Id. at 867 (quoting Pipitone v. United States, 180 F.3d 859, 862 (7th Cir. 1999)). Where the agreement does not mention purpose, the Court may look at other facts that reveal the payor’s intent, such as amount paid, evidence adduced at trial, and the factual circumstances that led to the agreement. Id. at 867-868; see also Robinson v. Commissioner, 102 T.C. 116, 126 (1994) (noting that the determination of the nature of the claims settled “is generally made by reference to the settlement agreement in light of the surrounding circumstances”), aff’d in part, rev’d in part, and remanded on another issue, 70 F.3d 34 (5th Cir. 1995).[9]

When the Court looked at this settlement, it concludes the agreement is for legal malpractice and not simply an award for the recovery of capital:

The settlement agreement makes clear that the settlement proceeds were in lieu of damages for legal malpractice. The text of the settlement agreement indicates its purpose was “to compromise and settle * * * [petitioner’s] claims and allegations” against malpractice defendants and that payment “in exchange for” release of claims related to petitioner’s lawsuit against the malpractice defendants.[10]

The Court rejects Ms. Holliday’s claim that this amount was a recovery of capital she should have received from the divorce, noting:

…[T]he settlement agreement says that the settlement proceeds are for the release of “all claims * * * of whatever kind or character, known or unknown * * * which * * * [petitioner] may have against * * * [malpractice defendants] arising out of or related to the * * * [malpractice lawsuit].” Petitioner thus asks us to look through the settlement agreement and consider only her claims related to recovery of marital property. We decline to look beyond the plain terms of the settlement agreement, and we conclude that the settlement proceeds were to compensate her for her attorney’s malpractice and therefore are taxable.

… Petitioner similarly has failed to convince us that the settlement proceeds were meant only to replace her marital property, rather than generally to release the malpractice defendants from the various claims and types of damages listed in the malpractice petition.[11]

The Court explains that it will not attempt to convert a malpractice claim into awards wholly of a type that would be excludable income.

We recently rejected a similar attempt to recharacterize the settlement of a legal malpractice claim arising from a personal injury lawsuit. In Blum v. Commissioner, T.C. Memo. 2021-18, the taxpayer filed a malpractice claim against her personal injury attorney, resulting in a settlement payment from the personal injury attorney. She asserted that the settlement payment represented a return of capital “in that it compensated her for a loss that she suffered because of the erroneous advice of her lawyers, viz, the nontaxable amount she would have received had she prevailed in her personal injury lawsuit.” Id. at *12. Focusing on the text of the settlement agreement, which specified that it was entered into “for the purpose of compromising and settling the disputes”, the Court concluded that the settlement payment was not a return of capital to the taxpayer but rather to compensate her “for distinct failings by her former lawyers.” Id. at *9, *12.[12]

And, to add insult to injury, the Court agreed with the IRS that she is required to include the entire award in income, not just the net amount shown on the Form 1099MISC issued by her attorney:

…[R]espondent has met his burden of proof with respect to the increased deficiency by showing that the $73,500 that yielded the increased deficiency was received by petitioner as settlement proceeds. The record includes uncontested evidence (and the parties have stipulated) that the settlement consisted of $175,000, of which petitioner’s malpractice attorney retained $73,500 as a fee for representing her in the lawsuit. The full amount of the settlement proceeds, including the fee petitioner paid her malpractice attorney, is includible in gross income. Commissioner v. Banks, 543 U.S. at 430 (noting that the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee).[13]

[1] Holliday v. Commissioner, TC Memo 2021-69, June 7, 2021, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/malpractice-settlement-proceeds-included-in-income/76kw5 (retrieved June 13, 2021)

[2] Holliday v. Commissioner, TC Memo 2021-69, June 7, 2021

[3] Holliday v. Commissioner, TC Memo 2021-69, June 7, 2021

[4] Holliday v. Commissioner, TC Memo 2021-69, June 7, 2021

[5] Holliday v. Commissioner, TC Memo 2021-69, June 7, 2021

[6] Holliday v. Commissioner, TC Memo 2021-69, June 7, 2021

[7] Holliday v. Commissioner, TC Memo 2021-69, June 7, 2021

[8] Holliday v. Commissioner, TC Memo 2021-69, June 7, 2021

[9] Holliday v. Commissioner, TC Memo 2021-69, June 7, 2021

[10] Holliday v. Commissioner, TC Memo 2021-69, June 7, 2021

[11] Holliday v. Commissioner, TC Memo 2021-69, June 7, 2021

[12] Holliday v. Commissioner, TC Memo 2021-69, June 7, 2021

[13] Holliday v. Commissioner, TC Memo 2021-69, June 7, 2021