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IRS scrutiny in settlement agreement for tax treatment

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    The IRS and the courts consider the complaint to be the most persuasive piece of evidence concerning the character of a recovery. The “complaint” is the document that outlines all the of plaintiff’s “causes of action”—or legal theories—like negligence, assault, fraud, and the like. It will also contain facts supporting these causes of action.

    Under Rev. Rul. 85-98, the IRS has stated that it considers the complaint the most persuasive piece of evidence concerning the character of a recovery. Factors such as the nature of the claims set forth in the complaint, the individual merit of the claims, and the prayer for relief are to be considered in determining validity of the classification and allocation of payments.

    As an example of how important the complaint is consider Gunderson v. Commissioner, T.C. Memo 1979-99. There, the complaint failed to state a claim based on personal physical injury or sickness, and the Tax Court therefore held that the settlement could not be excludable under Section 104(a)(2). Similarly, where a complaint sought only compensation for lost profits, the settlement agreement characterizing a recovery as a long term capital gain would not be respected. Longino Estate v. Commissioner, 32 T.C. 904 (1959).

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