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Lawsuit Awards and Settlements

Table of Contents

Chapter 5, Third Party Contacts and Summons Information

Note: The following information concerning third party contacts and summons should be read in conjunction with the provisions of the 1998 RRA in IRC sections 7602 and 7609. These provisions require taxpayer notice in many cases prior to the commencement of third party contacts and new notice requirements for summons issued to third parties. In addition, compliance Initiative Project (CIP) guidelines should be followed.

Third parties may be potential sources of a variety of information. As indicated earlier in this guide, the Service may be seeking information about the very existence of lawsuit settlements. Moreover, even if aware of the existence of a settlement, the Service may need to contact insurance companies or plaintiffs' attorneys to identify the specific recipients, and/or determine the specific amounts disbursed to each of the recipients in the settlement. The various devices for obtaining such information from third parties are noted below.

Third Party Letter

Examiners should initially attempt to secure needed information from the defendant companies (mainly insurance companies) by orally requesting the companies to provide the information voluntarily. If a company declines to produce the information in response to an oral request, examiners should attempt to obtain the information through the use of a third party request. Either the third party letter or a summons can be used both to request information with respect to a specific taxpayer or to request information on lawsuit settlement payments in general.

In a situation where a third party letter is issued to an insurance company, ask the insurance company's attorney to review the third party letter. Discuss the third party request, pointing out that the letter is issued under the same Code section which authorizes issuance of a summons (IRC section 7602). Where third party requests (either oral or written) do not pertain to a specific taxpayer, they are not subject to the same statutory control as a third party summons. However, in instances where the third party letter pertains to a specific taxpayer, IRC section 7602(c), as revised by the RRA, may apply to require that notice to the taxpayer be provided before the letter can be issued.

The Service is not responsible for any costs incurred in responding to a third-party letter. Ask the insurance company's attorney to review the confidentiality clause in the settlement closing agreement, if applicable. If there is a confidentiality clause, it often does not restrict the release of the facts of the case to the Service. Even where it does restrict release of the facts, the Service may legally be entitled to the information, as IRC section 7602 authorizes the Service to obtain any information that may be relevant to the determination and collection of a tax liability.

The company may respond to the third party letter; however, some companies will require a summons.

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Issuance of Summons

The manager must approve the issuance of a summons. Form 1334, Requisition for Equipment, Supplies or Services, has to be submitted for approval. An estimate of the cost must be included on Form 1334. Ask the insurance company's attorney for an estimate of the costs. Use Form 6863, Invoice and Authorization for Payment of Administrative Summons Expense, to explain to the insurance company's attorneys the amounts the Service will reimburse. Once the requested information is received, the invoice should be submitted with a copy of the approved Form 1334, Form 6863, and a copy of the front page of the summons to the appropriate office for payment. These procedures may vary from location to location. In addition, discuss the prospective summons with the insurance company's attorney to attempt to determine whether the insurance company will honor a summons mailed to them, and the attorney's response should be documented in the case file.

Moreover, the summons should be carefully drafted to specify the information being sought. Certain procedures differ depending on whether the summons is issued with respect to a known taxpayer, specific taxpayers, or an unknown taxpayer. Where the taxpayer is known, he or she is required to be given notice of a summons issued to a third party, such as an insurance company, under section 7609 as amended by the RRA. This notice must be provided within 3 days of service of the summons on the third party. Moreover, where a summons is issued to a third party for information on more than one taxpayer, a separate summons must be issued with respect to each taxpayer. Where the specific taxpayer is not known, the requirements set forth below under "John Doe" summons are applicable. Be sure the insurance company's attorney understands what information you need because the Service is legally required to pay for the information, even if you cannot use it.

Follow up with the insurance company attorney after he or she receives the summons. Discuss items on the information request. Some companies do not want to release Social Security Numbers and other policy information because of privacy concerns. If the insurance company's attorney has a problem with any item, look for alternative sources to get your information. For instance, Social Security Numbers can be obtained through Integrated Data Retrieval System (IDRS) research.

Set a response date. The Manual provides that 23 to 26 days should be allowed for responding to a third party summons involving an identified taxpayer. This period cannot be extended unless the summoned party is unable to appear. Follow up every couple of weeks to see if there are problems or concerns.

"John Doe" Summons

In certain circumstances you may be faced with the situation of considering the use of a "John Doe" summons. This is the only means of serving a summons where information is sought with respect to one or more unknown (nonspecific) taxpayers. IRC section 7609(f) defines a "John Doe" summons as "* * * any summons which does not identify the person with respect to whose liability the summons is issued." The Code requires the Service to obtain court approval to serve a "John Doe" summons. Moreover, the Code requires the Service to show the court that the following conditions are met:

  1. The summons relates to an investigation of a particular person or an ascertainable group or class of persons,

  2. There is a reasonable basis for believing that such persons or group or class of persons may fail or may have failed to comply with any provisions of the Internal Revenue law; and

  3. The information sought to be obtained from the examination of the records (and the identity of the person or persons with respect to whose liability the summons is issued) is not readily available from other sources.

Due to these restrictions on serving a "John Doe" summons, this type of summons is only appropriate in limited circumstances. The appropriate Office of Chief Counsel must be involved at the very beginning of any plans to use a "John Doe" summons. Always consult the IRM when considering a "John Doe" summons. Request only information on cases for which settlement payments have been made, that is, ask the company to note which cases are on appeal.

Third-Party Summonses

IRC section 7609 as revised by RRA 98 requires notice procedures for issuance of a summons to all third parties.

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Other Considerations

Attorney-Client Privilege

It is standard practice for the insurance company (payor) to disburse the gross amount of the settlement to the plaintiff's attorney, who then disburses the money to his or her client(s). A third party letter can be issued to the plaintiff's attorney in an effort to obtain the other names, and the amounts involved, in the settlement payment. Often, the attorney will refuse to respond to the third party letter. If so, it is not recommended that a summons be issued to the plaintiff's attorneys for disbursement information relevant to the settlement due to the potential for protracted litigation over claims of attorney-client privilege, which some attorneys may give as the reason for denying the requests for information. Although attorney-client privilege is a valid basis for not providing some requested information, fee arrangements usually fall outside the scope of the privilege. Such information ordinarily reveals no confidential professional communication between attorney and client. Determining whether this is true in a specific case requires coordination with the appropriate Office of Chief Counsel.

Moreover, due to the possibility of time-consuming litigation, it is recommended that all other means be exhausted in securing the disbursement information. Contact each plaintiff (taxpayer) to determine the amount paid by the insurance company and then disbursed through the attorney. Review the MSSP audit techniques guide on Attorneys for more information concerning attorney-client privilege.

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References
  1. Refer to IRM on the following:

    1. The definitions of specific terms relative to the summons and its issuance;

    2. The use and enforcement of a summons; and

    3. The restrictions on issuance of third party summons.

  2. See IRC sections 7602, 7203, and 7604.

  3. MSSP audit techniques guide on Attorneys.

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Chapter 6, Building the Case File

An examination case file is set up for individual taxpayers when a determination is made on which lawsuits to pursue. The case file should include information needed to conduct the examination.

Identifying the Taxpayer

There are usually three ways to secure the taxpayer's Social Security Number (SSN). If third party contacts were made, then the SSNs and addresses of these taxpayers will have been secured through these requests. Another method is to use Corporate Files on Line (CFOL) commands to obtain SSNs. If the examiner is still unable to get a SSN through these techniques, a more thorough review of the case file at the courthouse may reveal additional leads. The case file may have a SSN that was overlooked during the initial gathering of information or it may provide another address to use in the IDRS research.

Information Necessary for the Examination Case File

Use CFOL commands to determine if the plaintiff filed a tax return and to obtain a copy of the return. Look at the copy of the return to determine if the lawsuit proceeds were included in income. If the plaintiff did not include the lawsuit proceeds in income, an examination should commence. Follow the usual procedures to start an examination. If no return was filed, follow delinquent return procedures.

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Chapter 7, Examination Considerations

Scope of Examination

The scope of the examination may be limited to the lawsuit proceeds issue. However, the scope should be expanded in cases where other issues need to be addressed using customary examina-tion criteria. Sufficient steps should be taken to thoroughly develop the facts of each case to determine the factual basis of each settlement.

Examination Action Plan

  1. Once a constructed file, which includes the necessary IDRS research, is received by the examiner, he or she will contact the taxpayer to set up the initial appointment. The appoint-ment letter to be used will depend on whether the taxpayer has filed a tax return or not. The appointment letter should include a document request including the items shown in Appendix C. NOTE: This step in the examination process can be done by group clerks or management aides. Due to the nature of the issues involved, and the fact that most of the taxpayers involved are wage earners, most of these examinations will probably be held in the office. However, there are instances that would require field visits. For example, the taxpayer has a business that also requires examination.

  2. The most important step of the examination is the development of the facts. The case file should include, at minimum, the original complaint and pleadings, the settlement agreement or release, the disbursement schedule or a clear statement of how the funds were disbursed, and a copy of the agreement relating to the attorney's fee arrangement. These documents are critical in the development of the facts of the case and are vital to Counsel if the case should go to court. In addition, because of the provision in IRC section 7491 concerning the potential for shifting the burden of proof to the government when taxpayers reasonably cooperate with the IRS, examiners should carefully document the level of cooperation taxpayers demonstrated during the audit process.

  3. The next critical step in the examination is to determine the allocation of lawsuit proceeds between punitive and compensatory damages. If the proceeds were received as a result of a litigated case, the amount of punitive and compensatory damages is usually made clear in the court documents, and there may be no further work to be done in making the allocation. However, it is more difficult to make that determination for cases settled out of court. The settlement agreement does not usually make a distinction between the punitive and compensatory damages awarded. These settlement agreements are usually silent as to the types of damages awarded, or they state that all of the damages awarded are "compensatory." Therefore, it is essential that all the facts surrounding the lawsuit be determined and documented. The allocation between compensatory and punitive damages must be made based on the facts of each case. In making this determination, the following items should be considered:
    1. The intent of the payor in making the payment to the plaintiff. Why did the payor settle? For what was the payor paying?

    2. The nature of the claim underlying the plaintiff's award. What was the reason for the suit?

    3. The negotiations between the plaintiff and defendant. Review the case file. Was there a meeting of the minds by the parties?

    4. The actual amount of money it would take to make the plaintiff whole. Did the plaintiff make insurance premium payments or was the plaintiff to receive a certain amount of insurance proceeds? The settlement amount that the plaintiff receives to reimburse him or her for these types of costs are usually compensatory.

    5. If the plaintiff claims to have suffered from mental pain and anguish, determine if the plaintiff received medical treatment for the mental pain and anguish. If so, does he or she have verification of the amount spent for this treatment? Can he or she show that the treatment is directly related to the lawsuit case? In other words, the plaintiff must show that he or she was being made "whole" from the total amount of the settlement received in order for the whole amount of the settlement to be non-taxable. The taxpayer bears the burden at the audit stage of showing that the damages received are excludable from gross income under IRC section 104(a)(2), (although that burden may shift to the government if the issue reaches litigation and the taxpayer satisfies the requirements of IRC section 7491).

      Note: The most difficult issue in these cases is the determination of the punitive and compensatory damages when there is a settlement agreement. Normally, it is reasonable for some portion to be allocated to compensatory damages in most cases. Develop the facts carefully and objectively for each case.

  4. Determine if the taxpayer received any client advances from the attorney. If the taxpayer received advances from the attorney, ensure that the settlement proceeds were not reduced by these advances. Also, determine if the advances were erroneously characterized as legal fees that would provide the taxpayer with a deduction for personal expenses.

  5. Once a determination is made regarding the allocation of the punitive and compensatory damages, the punitive portion of the damages is considered taxable. It is the Service's position that the taxpayer is to be taxed on the full amount of the punitive damages before the attorney is paid any fees. In other words, the taxpayer cannot report the "net" punitive proceeds received. Note: this is an issue that has been litigated continuously.

    The taxpayer must include in income the gross amount of the award deemed to be taxable. A deduction is allowed for the legal fees and court costs that are related to the taxable portion of the proceeds. The legal fees and court costs are allowed as a miscellaneous itemized deduction subject to the 2-percent AGI limitation on Schedule A. The deductible fees and costs are determined by using the ratio of taxable proceeds to total proceeds and multiplying the total fees and costs by this ratio. The following is an example. 


    
  Total lawsuit proceeds received              $100,000

  Taxable lawsuit proceeds(80% taxable)          80,000

  Legal fees and court costs                     52,000

  COMPUTATION OF DEDUCTIBLE FEES AND COSTS:

  Total fees and costs                          $52,000

  Taxable Ratio (80,000/100,000)                 X  .80
                                                _______

  Deductible fees and costs*                    $41,600*
                                                =======

    *subject to 2% AGI limit

    Note: When allowing this as a deduction, consideration should also be given to any other itemized deductions to which the taxpayer may be entitled but did not deduct on the original return because their itemized deductions were less than the standard deduction amount.

  6. AMT must be considered because of the allowance of the miscellaneous itemized deduction. AMT usually becomes due when there is a large amount of miscellaneous itemized deduc-tions. Miscellaneous itemized deductions subject to the 2-percent AGI limitation are a tax preference item for alternative minimum tax purposes. The Report Generating Software (RGS) program for producing Revenue Agent reports will automatically compute this tax.

  7. The following issues should also be considered when making the adjustment to income for the lawsuit proceeds:
    1. Earned Income Credit - If the taxpayer claimed the Earned Income Credit on the original filed return, then it may have to be recaptured as a result of the increase in income from the lawsuit.

    2. Social Security Income - If the taxpayer received any type of Social Security income, the taxable portion of this income may be increased due to the increase in income from the lawsuit.

    3. Exemption - The personal and dependent exemptions taken by the taxpayer may be limited or phased out due to the increase in income from the lawsuit. This is an automatic adjustment and will be computed by the RGS program for producing Revenue Agent reports.

    4. Itemized Deductions - Itemized deductions taken by the taxpayer may be limited or phased out due to the increase in income from the lawsuit settlement. This is another automatic adjustment that will be computed by the RGS program for producing Revenue Agent reports.

    5. Rental Real Estate Losses - Rental Real Estate Losses could be limited due to the increase in modified AGI. If the modified AGI exceeds the threshold, then passive losses will be limited. The RGS program for producing the Revenue Agent reports will not automatically compute the allowable passive losses.

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Chapter 8, Penalties

Examiners are responsible for considering the application of penalties in all cases under examination. Many lawsuit settlement cases involve taxpayers who normally do not have to file returns except for the settlement proceeds received. However, returns are still not filed in some situations because the taxpayers and their representatives concluded the proceeds are not taxable. For returns that are not filed, the following penalties should be considered:

  1. Failure to file penalty (IRC section 6651(a)(1))

  2. Estimated tax penalty (For Individuals: IRC section 6654)

  3. Fraud or negligence (Pre-1989 only: IRC section 6653)

  4. Fraudulent failure to file (Post 1988: IRC section 6651(f))

The accuracy-related penalty applies only where a return is filed and is not applicable to substitutes for returns filed under authority of IRC section 6020(b). These provisions apply to all returns due to be filed after December 31, 1989, without regard to extensions filed.

There is no reasonable cause exception to the IRC section 6654 penalty for underpayment of estimated tax by an individual. The penalties apply unless the taxpayer meets certain specified statutory exceptions. However, in the case of an individual, IRC section 6654(e)(3) provides that the Service may waive the penalty if the Service determines it would be inequitable, due to casualty, disaster, or other unusual circumstances. The Service may also waive the penalty if the taxpayer has retired or become disabled during the taxable year and his or her underpayment was due to reasonable cause and not to willful neglect.

The failure to pay penalty applies to original and amended returns filed by the taxpayer. With regard to returns due prior to June 30, 1996, the failure to pay penalty does not apply when the taxpayer does not file a return or if the return is filed under IRC section 6020(b) substitute for return procedures. With regard to returns due after June 30, 1996, the Service may impose the failure to pay penalties where the taxpayer fails to file a return and a substitute return is prepared by the Service under IRC section 6020(b). IRC section 6651(g).

Lawsuit settlement cases usually result in significant adjustments to income. As in other cases where there are large amounts of unreported income, the accuracy-related penalty and fraud penalties must be considered. Factors to consider in determining whether penalties are warranted include:

  1. Did the lawsuit settlement recipient adequately disclose all pertinent facts of his or her case to his or her attorney?

  2. What advice, if any, did his or her attorney provide regarding the taxability of the settlement amount? and

  3. Should the taxpayer have questioned the advice of his or her attorney regarding the taxability of the payment?

All the facts and circumstances in each case should be considered before making a determination regarding penalties. If the taxpayer received interest income from the settlement and did not report it, more consideration should be given to assessing the accuracy-related penalty on the interest income issue.

If penalties are recommended, the examiner's workpapers should contain comments regarding the examiner's reasons for asserting penalties. If reasonable cause was available and considered, the examiner's workpapers should explain why it was or was not established.

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