Sample Answers to Question 1

Exam #6586

The first event at issue is in connection with damages received in connection with a lawsuit settlement stemming from an automobile accident. Amy claimed 500,000 in compensatory damages and one million in punitive. Under the underlying nature test, punitive damages are taxed as a windfall. Additionally, lost earnings are taxed similar to taxable income. Similarly, provided medical care, pain and suffering and emotional distress would be taxed. However, with the exception of punitive damages, damages received fall under the IRC 104 exception because they arise from a personal and physical injury. It should be noted that since the medical bills have not been paid, there has been no deduction. Thus medical bill damages are not taxable. Additionally, pain and suffering damages falling under the 104 exception (pers/physical) are not taxable.

Having concluded that only the punitive damages are taxable, we have to determine what, if any, amount of the damages should be allocated to the punitive claim. There is no clear answer nor any indication of the intent of the parties in the settlement agreement. The payor will likely state that all the damages are compensatory. Another factor in favor of Amy is the fact that the damages accepted fall below the $500,000 compensatory claim. However, Amy will not want to say that she had no right to punitive damages, as this will open her up to a Rule 11 frivolous suit claim.

If any of the damages are deemed punitive, they will be taxed at ordinary rates (not property) on receipt. Otherwise, Amy will incur no tax.

Amy may also try to claim a deduction for medical expenses exceeding 7.5% of her “AGI” if she itemizes her tax return. If it is concluded that the settlement covers her medical bills, no deduction will be allowed. However, if it is shown (possibly with the help of the payor) that not all of the medical expenses were due to the accident and, thus, were not covered by the damages, these expenses (over the 7.5% threshold and assuming no phase down of benefits) would be deductible in the taxable year of the settlement (ordinary rates). The fact that she paid the bills out of the settlement further indicates the settlement covered these expenses. Thus a deduction is unlikely.

The second tax issue has to do with the sale of water rights. Upon purchasing the property, Amy paid $100,000. Her cost basis is $100,000. When she purchased the property her water rights were uncertain. Sale of the water rights is a realizing event. The amount realized in 2001 is $65,000. The real issue is what portion of the $100,000 basis to apportion to the sale of the water rights. Inaja is the current law but some conflicting precedents have emerged. First, I will examine the sale under Inaja. Since this case is quite similar to Inaja, Amy can argue that it is wholly impracticable to valuate the water rights. If this argument is accepted, Amy can use her entire basis to offset the property sale gain. Accordingly, Amy would use $65,000 of her basis to reduce her income to $-0-. Her adjusted basis would be reduced to 35,000 (100K-65K).

There are counterarguments that can be raised to Amy’s claim, especially in light of Gladden. First, it could be argued that none of the property purchase price went to the water rights because they were too uncertain. If this argument was accepted, Amy could not use the $100,000 to offset her gain. Thus, she would realize a gain of $65,000 and her basis would remain at $100,000. This argument is unlikely to be accepted because, while the water rights were uncertain, it can be argued that she paid for a “chance” of water rights.

A more plausible counterargument, under Gladden, would be that only part of the basis can be apportioned to the water rights. An appraiser could value the property with and without water rights (or similar) property. The basis allocated to the water rights could be said to equal the % of the value of the water rights to the entire property with water rights. If the water rights accounted for 50% of the property value, $50K in basis could be used. A gain of $15,000 (65K -50K) would be realized and the remaining basis would be $50,000 (100K -50K).

If a gain is realized, it will be recognized because no non-recognition provision applies. It will be recognized in 2001, the year of the sale. Because we are dealing with (1) a property sale under IRC 1001, (2) a sale occurred and (3) a capital asset (held for more than a year, not excluded), the tax rate imposed will be capital gain. Personal use assets (non-depreciable real estate) are privy to the favorable capital gain rate.

The final income at issue is the $150,000 business profits received in 2000. Because litigation was pending, the profits went to the receiver in 2000. Amy will not be taxed in 2000. First, she had no constructive receipt of the funds because they were still in dispute and not set aside for her. More importantly, Amy did not have a claim of right to these funds because no final judgment had been rendered.

The $150,000 in profits will be taxable to Amy upon receipt in 2001 under the Claim of Right Doctrine. At this point, Amy obtains a final judgment stating that she is entitled to the funds. Thus, even though an appeal is pending, she has a claim of right to the funds because there is no use/disposition restriction. Since the income does not involve a property sale, she will be taxed at ordinary income rates.

It should be noted that any ordinary and necessary business expenses can be deducted under IRC 162 by Amy. Additionally, since the origin of the claim is business in nature, and because Amy is the defendant, Amy should be able to deduct her attorney fees in 2001.

Finally, if Pearl wins on appeal, Amy will have to return the $150,000 plus interest. Since this is in excess of $3,000, under IRC 1341, Amy will receive (“Best of both worlds”) a deduction computed either based on the tax year rates in 2001 (previous tax year of receipts) or based on the current tax year.

Exam #6759

There are probably no tax consequences to Amy from the settlement, because none of the recovery Amy received as a result of her car accident is included in her gross income. Amy suffered personal physical injuries from the accident, and thus falls into the category of damages in IRC 104 that compensation for physical injuries is not income. While Amy also claimed psychological and emotional distress, as well as lost earnings, each of which standing alone would constitute income, the fact that she suffered personal physical injuries makes the entire recovery excludable from income. The only potential problem is that Amy initially sought punitive damages; punitive damages do not fall within § 104; the key is to determine whether the payor of the settlement intended for part of the lump sum payment to constitute a settlement of potential punitive damages. Because the settlement is less than the amount of compensatory damages claimed – Amy requested the punitives separately – there is no indication from the facts presented that the payor intended part of the lump sum payment to include a settlement of punitives. To be sure, Amy’s attorney should examine the settlement documents to find out what the payor intended. Furthermore, the facts do not suggest that Amy has deducted any amount of medical expenses prior to the settlement; to the extent that she has deducted any amount as a medical expense, the tax benefit rule would kick in and she would have income in the amount she previously deducted, to be reported on her current tax return.

As for Amy’s purchase of property, she has a cost basis in the property as a whole of $100,000, the amount she paid for it. At issue is how much of this basis should be applied to the sale of Amy’s water right for $65,000. A similar situation arose in Inaja Land, where the court held that the seller could use as much basis as he wanted to cancel out the gain from the sale of the water right. However, the Ninth Circuit recently narrowed Inaja in Gladden, holding that for tax purposes the taxpayer should attempt to determine the value of the right sold and then allocate a portion of basis between the parts sold and not sold. From the facts presented here, there is no way to know the premium that Amy paid for the water right on her property, because at the time of purchase the water right was not clearly established (there may or may not have been a water right); as such, the purchase price is not a good indicator. Amy and her tax preparer should examine the value of similar properties in her area with and without water rights, and then determine what proportion of the value of the property as a whole is attributable to the water right. Once she has made that calculation, Amy must then apply a portion of the basis to the sale of the water right that corresponds with the proportion of the property’s value attributable to the water right. Only if there is no way to determine how much of the property’s value is attributable to the water right can Amy look to Inaja and apply $65,000 of her basis to cancel out any gain from the sale. Furthermore, any gain Amy realizes on the sale of the water right will be considered capital gain, as her property and its appurtenant water right constitute an asset held for Amy’s personal use.

As for the lawsuit brought by Pearl, Amy does not have to report the $150,000 of income on her 2000 tax return, because she did not receive it in that year actually or constructively. She had no legal right to get the money, because it was in the hands of the receiver. However, she does have to report the $150,000 on her 2001 tax return, because she received the money under a claim of right without restriction in that year. The fact that Amy may have to turn over the entire $150,000 to Pearl if her appeal is successful is irrelevant for determining whether the income is income to Amy in 2001. If Amy does have to return the money, under § 1341 she will be entitled to a credit for the amount of tax paid on the $150,000 in 2001, calculated as either the amount of tax due in the year she has to pay it back with a deduction for the amount of tax paid on the $150,000 in 2001, or by giving her credit for the excess amount paid in 2001 (the difference between what she paid in 2001 with the $150,000 included and what her tax would have been in that year had the $150,000 not been included in her income).

There is no way to know how much of the $150,000 will be subject to tax, or whether any part of it represents capital gain, because the facts don’t indicate how much of the income will be offset by deductions or depreciation, or whether any of the income resulted from the sale or exchange of capital assets.

Furthermore, any legal fees that Amy spent defending the lawsuit are deductible, because the origin of the claim – the alleged sale of her business to Pearl – is business-related.

Exam #6805

Auto Accident

In determining whether damages received in a tort type lawsuit like Amy’s should be included in her gross income for that taxable year the initial inquiry is “what are the damages replacing?” If the answer is profit/income then the general rule is that the damages are includable as gross income. However, this general rule is subject to exceptions in IRC § 104(a)(2), which excludes from gross income any damages (other than punitive damages) received on account of personal physical injuries.

In Amy’s case, she has suffered a physical injury so the § 104(a)(2) exception applies to exclude from gross income all of the damages she seeks for medical care for physical injuries (unless she has already deducted them in a prior tax year – see tax benefit rule); professional psych care for psych injuries (b/c there is a physical injury – these are covered under medical expenses); physical pain and suffering; emotional distress (again since there is a physical injury, resulting damages for emotional distress is excludable); and loss of income is also excludable.

Whatever damages Amy received as punitive damages are not excludable and therefore are gross income. See also Glenshaw Glass. This reveals the allocation problem involved in Amy’s settlement. She received a lump sum of $300K, so the question is how much should be allocated to each element of damages. Amy would want none of the money allocated to punitives so she could exclude it all from gross income under § 104. She could ask the defendant to put it in writing but this probably wouldn’t carry much weight, and the courts usually say the allocation is based on the intent of the payor. Therefore, the fact that Amy actually used $135K to pay her medical and psych bills may be irrelevant, especially since the defendant thought that Amy’s physical and psych. problems pre-dated the accident -- might say intent was simply to pay punitives (all 300K).

If that was the case, Amy would have to include 300K as gross income but she could then deduct (below the line) her medical expenses from that income b/c (assuming that was her only income for that year) those medical expenses would be greater than 7.5% of her AGI. Under § 213 she would be able to deduct the excess above 7.5% of her AGI.

Property Purchase

Amy's basis in her land is her cost basis in 1997 when she bought it, $100K. At the time she purchased the land, her water rights were unclear.

There are potentially two results. If it can be shown that a “premium” was paid when Amy bought the land — based on an expectation of water rights (this might be done by looking at the comparable land values in the area where the water rights are even less sure than “unclear”) then at least in the Ninth Circuit, Amy could allocate an amount of her basis in the property equal to the amount of that premium (which logically would be something probably less than 65K). This would reduce her 100K basis in the property by that amount and any difference between that amount and the 65K she received for the water rights would be capital gain. See Gladden v. Com; Reg 1.61-6(a). (Against which she could deduct any capital losses she might incur in that year or previous years she has carried forward.)

If however, no premium can be proven (her expectation of water rights is just too unclear) then Amy would be able, under Inaja Land, to use as much of her basis was necessary to zero out any gain she had by selling the water rights — in this case 65K. Under this scenario, Amy’s new basis in the property would be 35K, and she would have no capital gain on the sale of the water rights. This is not completely settled law, but how it looks the Ninth Circuit might rule after the Gladden decision.

Business

Under the claim of right doctrine, a taxpayer must include an item of income in the year in which the item was received, even if later events may require the item to be returned. See North American Oil Cons. Here Amy has received $150K of ordinary income in 2001 so she must include that income as gross income. If in the future, Pearl wins an appeal and Amy must turn over the business, plus 150K, plus interest to Pearl, she will likely want to deduct all of it as a loss (which she would be able to do under § 165). At that point, Amy has two options under § 1341: she can either (1) take the deduction in the year she is forced to turn over business to Pearl, but if she doesn’t have gain to deduct against or her tax bracket status has changed in some way she can (2) compute her tax in the year she has to give the income to Pearl in a special way that gives her credit for the tax she paid on the $150,000 in 2001.