TAX LANGUAGE IN SETTLEMENT AGREEMENTS: BINDING OR NOT?

It is more and more common today for litigants to attempt to set forth tax characterization and tax reporting language in settlement agreements. Indeed, this is almost always a good idea. Tax allocation language and tax reporting language helps to avoid misunderstandings and disappointment, and sometimes, even further litigation. Plus, the settlement agreement represents the last defining moment of the litigation and is likely to have a significant impact on tax treatment.

But is this tax treatment binding? Specifically, is it binding on the parties and their treatment of the items? Is it binding on the Internal Revenue Service and state taxing agencies? Is it binding on the courts?

Parties
Properly crafted tax language will be binding on the parties. If the defendant agrees to make payment in a certain fashion (for example, to withhold income and employment taxes only on 50% of a settlement), and then the defendant fails to live up to this bargain, the settlement agreement has been breached. Although I rarely see such conduct, in situations where I have seen it, a breach of the settlement agreement is normally remedied quite quickly. Where this does occur there has usually been come disconnect and the error is unintentional.

Still, it is always nice to be able to point to specific provisions in a settlement agreement and to demand that the mistakes be corrected. This is especially so with the issuance of Forms 1099, which often are not prepared until up to a year after the settlement is struck. While sometimes Forms 1099 are prepared with the settlement checks or wires, more commonly they are prepared the following January, to meet the deadline of January 31 following the year of payment for issuance to the taxpayer and February 28 for issuance to the government.

It is not so clear what should occur if the settlement agreement calls for tax treatment or tax reporting that conflicts with the law. For example, suppose that a settlement agreement specifies that of a $1 million settlement payment, $500,000 is to be paid to the plaintiff (and a 1099 issued to the plaintiff), and $500,000 is to be paid directly to the plaintiff’s contingent fee lawyer (and a 1099 issued only to the plaintiff’s lawyer). Despite the raging controversy about attorneys’ fees in the case law, I believe this kind of payment language is permissible. However, once the IRS issues regulations under Section 6045(f), which doubtless will specify that even in such direct payment situations, the plaintiff must be issued a Form 1099 for the money paid to the contingent fee lawyer, an express settlement agreement of the nature I’ve described would conflict with the law. Whether a defendant who chooses to follow the 1099 regulations would then be at risk with a contractual argument from the plaintiff (that the settlement agreement has been “breached”), is debatable. I have not yet seen this occur, but expect it will in the future.

Binding on IRS and the Courts?
Whether express tax language in the settlement agreement is binding on the IRS and/or the courts seems a simple question. I would have thought that virtually everyone (whether a tax specialist or not) would instinctively answer both of these questions with a “no.” The IRS and the courts have long stated that settlement language bearing on tax issues is not binding. That does not mean it is worthless. It is worth something.

How much it is worth may depend on the degree of bargaining that occurred and the degree to which the parties are truly at arms’ length. Parties in litigation are usually at arms’ length, and even downright hostile. But the question is whether they are at arms’ length over the tax issues in particular. A defendant who says “structure the $500,000 any way you want for tax purposes” is not at arms’ length.

Taxpayers have long attempted to make the tax provisions of a settlement agreement as strong as possible. One of the ways of doing this is to attempt to include reasonable allocations and payment language, and to actually negotiate it. However, a recent IRS announcement suggests that perhaps this is more important than was previously thought. Moreover, this IRS announcement seems to state the painfully obvious: that the IRS is not bound — at least where there is no evidence that the allocations were negotiated by the parties in a bona fide, arms’ length and adversarial manner.

Field Service Advice 200146008 (April 30, 2001), finally released by the IRS on November 16, 2001 after very heavy redacting, is a directive from the IRS Chief Counsel to a field office of the IRS dealing with precisely this topic. The Field Service Advice goes through the facts presented, which are quite common. A settlement agreement included express tax language. The question that the IRS field office submitted to the IRS Chief Counsel was whether it was bound to follow the tax characterization included in this settlement agreement. The Field Service Advice goes through extensive legal analysis about the origin of the claim being the deciding factor in the tax treatment of litigation recoveries.

Significantly, the IRS recognizes that the courts have tended to uphold the allocations in a settlement agreement where the record indicates there was a negotiated and bona fide settlement arrived at in an adversarial proceeding at arms’ length and in good faith. See McKay v. Commissioner, 102 T.C. 396 (1995), vacated on other grounds, 84 F.3d 433 (5th Cir. 1996); and Threlkeld v. Commissioner, 87 T.C. 1294 (1986), aff’d, 848 F.2d 81 (6th Cir. 1988). Not only did the IRS acknowledge these and other cases, but the IRS acknowledged that where express tax allocations are made in the settlement agreement, courts will carefully consider them. The IRS cites Byrne v. Commissioner, 90 T.C. 1000 (1988), rev’d and remanded, 883 F.2d 211 (3d Cir. 1989).

In its Field Service Advice, the IRS quotes from McKay, noting that there the parties were hostile adversaries, with both economic and other interests being affected by how the payments were characterized. The IRS noted that in McKay, the taxpayer was not given freedom to structure the settlement on his own. The Tax Court in McKay ended up accepting the express allocations in the agreement. In so doing, the Tax Court noted that the express language in the settlement agreement was the most important factor to the purpose of the payment (in this specific instance, under Section 104 of the Code). Despite this conclusion, the IRS quoted McKay that:

“[w]e are not bound, however, by any factor or factors that are inconsistent with the true substance of the taxpayer’s claim, nor are we bound by express allocations in a written settlement agreement if the parties did not engage in bona fide, arms’-length adversarial negotiations.” 102 T.C. at 482.

Ultimately, the Field Service Advice tells personnel within the IRS that it should treat settlement language as one factor in determining the treatment of the payments. But, it is not determinative. The FSA advises that the examining agent should inquire into the facts and circumstances of the payment, and the IRS can make a reallocation of the settlement amounts among the various claims resolved by the settlement. The FSA admonishes agents to first look to the terms of the agreement and to determine whether express allocations (if any) were negotiated by the parties in a bona fide, arms’ length and adversarial manner. In the absence of bona fide and adversarial negotiations, or if the settlement terms are inconsistent with the claims made by the plaintiff, or are entirely tax motivated, the FSA says the settlement allocation can be disregarded.

All this may not sound terribly helpful. Yet this FSA goes on to advise IRS agents to do the following. Prior to recharacterizing or reallocating the payments made pursuant to a settlement agreement, you (IRS agents) should first look to determine if: (1) it was a bona fide and adversarial settlement as to the allocation of payments between claims; (2) its terms are consistent with the true substance of the plaintiff’s claims; or (3) the allocation was not entirely tax motivated. If the IRS concludes that any of these criteria are not satisfied, then the FSA says it is appropriate to look to all facts and circumstances surrounding the settlement. This would include the details surrounding the litigation in the underlying proceeding, the allegations contained in the payee’s complaint and amended complaint in the underlying proceeding, and the arguments made in the underlying proceeding by each party. The object, of course, is to determine in lieu of what the damages were paid. See Robinson v. Commissioner, 102 T.C. 116 (1994), rev’d in part on other grounds, 70 F.3d 34 (5th Cir. 1995), cert. denied, 519 U.S. 824 (1996).

Conclusion
Apart from this recent Field Service Advice — which is the latest IRS pronouncement on the topic — there have been many cases over the years dealing with the import of express tax allocations. Long ago, in Revenue Ruling 85-98, 1985-2 C.B. 51, the IRS ruled that an allocation in the pleadings between compensatory and punitive damages would be followed in determining the taxability of a lump-sum award. Nevertheless, the IRS has generally argued that settlement language should be disregarded. Courts have sometimes agreed, and sometimes not. The McKay case, discussed above, is a prime example. Other excellent examples (not cited in the Field Service Advice) include Galligan v. Commissioner, T.C. Memo 1993-605 (1993), and George Knevelbaard, et ux. v. Commissioner, T.C. Memo 1997-330 (1997).

Knevelbaard involved a suit by 1,000 dairy farmers against several banks, alleging that the banks made a bad business deal that ultimately drove many of the dairy farmers out of business. The complaint contained twelve causes of action sounding in tort, and sought damages for mental suffering and emotional distress. A written settlement agreement awarding the dairy farmers $20 million allocated $19.3 million to the tort action (excludable from the dairy farmers’ income under the prevailing law), and $700,000 to negligent interference with contractual relationships. Despite the IRS’ vehement protest, the Tax Court upheld this allocation! Such a home run would never have been possible without an express allocation in the settlement agreement.

Today, more than ever, express consideration of tax issues ought to be a feature of every single settlement agreement.

Tax Language in Settlement Agreements: Binding or Not?, Vol. 17, No. 23, BNA’s Employment Discrimination Report (December 19, 2001), p. 728; Vol. 93, No. 14, Tax Notes (December 31, 2001), p. 1872.