It is not just plaintiffs that should consider the tax consequences of an award or settlement. Defendants should, as well. Payments made by a defendant may be fully tax deductible, partially deductible, or entirely non-deductible. There are various other concerns a defendant should have about the tax consequences of an award. For example:
Miscellaneous itemized expense deduction? Defendants should be concerned whether the payment is deducted as a miscellaneous itemized expense, as opposed to an “above the line” deduction, where the 2% AGI floor and the AMT may reduce or completely eliminate the amount allowable as a deduction.
Must the payments be capitalized? Where disputes involve capital improvements or the disposition of an asset, payments made by the defendant may need to be capitalized rather than deducted. Moreover, nondeductible expenses may arise where a payment is in relation to a fine or penalty levied on the defendant. Deductible fines and penalties may arise where they are intended to be remedial or compensatory in purpose, rather than punitive in nature.
Defendants often structure their settlement in ways to ultimately reduce the amount of damages paid out to plaintiffs. Case law expressly recognizes this. In Gregory v. Helvering, 69 F.2d 809 (1934), Judge Learned Hand famously stated:
“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes.”
Of course, there is an important and often fine distinction between a perfectly legal taxavoidance as described by Judge Learned Hand, and tax evasion which carries stiff civil and criminal penalties.
Our Office helps defendants structure their affairs so they may achieve tax favorable results, without committing a criminal offense. If one is unaware of this fine distinction, between tax evasion and tax avoidance, it is best to consult with a tax attorney who is. Interestingly, the IRS itself is oftentimes unaware of this distinction. Its website and published literature often (wrongly) uses the terms “tax avoidance” and “tax evasion” interchangeably.