It is difficult to assign a probability for a possible malpractice suit. However, the courts do hold attorneys liable for malpractice for failing to render competent tax advice on the tax consequences of litigation. For example, in Philips v. Giles, a divorce attorney faced malpractice where he failed to advise his client that payments she received as a result of the divorce settlement were taxable. Similarly, in Jamison, Money and Farmer & Co. v Standeffer, an accountant was found negligent for his advice concerning disability payments. And in Jalali v. Root, an attorney was found negligent where his advice on the tax consequences of the litigation was incorrect.
Because courts are often reluctant to state what the tax treatment is of a judgment amplifies the risk of malpractice. Further, even where a court does state the tax treatment, the tax authorities are not bound by it. For example where a judge issues an award to the plaintiff of $5,000,000 in a defamation suit and states that such a recovery is “tax free,” the taxing authorities do not have to respect the court’s tax classification.
The tax treatment of a recovery often turns on the nuanced case law that has evolved, rather than the by a statute. That is, the primary authority for the tax treatment of a recovery is determined by very nuanced case law—rather than the certainty found by statute. The only statutory authority is found under IRC Sections 104, 106 and 186 regarding the classification of income, and Sections 162 and 212 regarding the deductibility of legal fees.
Accordingly, because the risk of malpractice could be large for failing to consider the tax consequence of a transaction, award, or settlement could be large, the plaintiff and defendant attorney should work with competent tax counsel to help structure their client’s affairs for the most favorable tax treatment.