"The insurance company actually paid!

Now, is any of what I received

taxable?"
Robert E. Lynn
Bartley & Lynn, LLP
Saint Paul, MN
rlynn@bartleylynn.com

UP-FRONT COMMENT: Your immediate response to any tax question may be to say to your
client, talk to your accountant about that. But if the question arises from a type of claim that's a
core part of your practice, isn't it likely that you'll see the situation again, and get nearly identical
questions, many times? How often will your client's accountant see it? If you familiarize yourself
with the particular aspect of tax law, you'll be able to give the client some immediate, if general,
idea of what to expect. And you should be able to communicate with accountants about the tax
implications of the events, not in formal opinion letters, but at least to confirm that you agree
about the key concepts that will drive the results.

Also, regardless of which party you represent, in negotiating a settlement for any contested claim
you need a reasonably good idea of what the net-of-tax amount of an offer is.

Following are selected common situations in which your client might ask a tax question,
enduring principles that apply, and key information that you'll need to respond.

Coverage is limited to income taxation of individuals, and (with choses in action) only as it
affects the original claimants. Taxation of claims purchased or otherwise acquired by third
parties, and tax deduction issues affecting payors, are not addressed. As an overview or
refresher, a schematic diagram of the three separate income tax regimes now affecting
individuals is included. The focus here is on whether, and where, the amount of a given payment
and, if applicable, its associated legal fee, may be included in the computation of each regime's
tax base (i.e., taxable income).

All code section references are to the Internal Revenue Code of 1986 ("the Code"), as amended.
All regulations references are to those interpreting the Code, in 26 C.F.R.

I. Can the question be resolved without engaging in law practice?

A. A non-exclusive list of what accountants may safely do, according to Gardner:

"When an accountant or other layman who is employed to prepare an income tax return is faced
with difficult or doubtful questions of the interpretation or application of statutes, administrative
regulations and rulings, court decisions, or general law, it is his duty to leave the determination
of such questions to a lawyer. In so holding that the determination of difficult or doubtful
questions is the practice of law, it does not follow that the entire income tax field has been
preempted by lawyers to the exclusion of accountants. The work of an accountant disassociated
from the resolving of difficult or doubtful questions of law is not law practice... In the

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determination of income--the subject of taxation--difficult accounting problems may arise by
presenting 'such aspects as inventory pricing methods (last-in-first-out, first-in-first-out, retail
method, cost determination, actual costs, standard costs, cost of in-process merchandise, market
price valuation, etc.), accrual and installment accounting, carryover and carryback of net
operating losses, depreciation, depletion and corporate distributions. The taxation of such income
may involve such concepts as consolidated returns, taxable years of less than twelve months,
invested capital, etc. All of these are concepts of accounting ... Where difficult accounting
questions arise, the careful lawyer will naturally advise his client to enlist the aid of an
accountant. In the income tax field, the lawyer and the accountant each has a function to perform
in the interest of the public." [Emphasis added.]
Gardner v. Conway, 234 Minn. 468, 482-83 (1951).

B. When might resolving the tax character of an insurance payment implicate the practice
of law?

1. When a personal injury claim involves both physical and emotional injury, and the final
documents that memorialize the resolution don't specify what the elements of the payment
are. See section IV, below.

2. When a death benefit is paid on a life insurance policy that has been transferred prior to
the death of the insured, and the transfer was not unequivocally, unassailably a gift. See
section V.C, below.

3. When a claims for injuries to property or capital and claims for lost income have both
been asserted, and the settlement does not specify the portions of a total payment that are
allocable to each. See sections V.A through V.C, below.

II. Property damage claim against a taxpayer's own homeowners (HO) or

business property/casualty coverage

A. Was the event that resulted in the claim and payment under the policy a "casualty" or
"theft" as defined for tax purposes? If not, no deduction will be allowed for any shortfall in
the payment under the policy unless there are additional expenditures for repairs. But conversely,
there can be income if the payment exceeds the amount of loss.

1. A casualty is a sudden, unexpected, unusual event. Events arising from a gradual process,
such as termite damage, drought or disease (e.g., tree blight), generally won't qualify. Rev.
Rul. 76-134, 1976-1 CB 54.

2. A theft is a taking of property in a manner that is illegal under state law where it occurred,
and done with criminal intent. A theft occurs for tax purposes in year of discovery.
Sec.165(e).

COMMENT: If the event doesn't qualify as a casualty or theft for tax purposes, it may not be
cost effective to insure for it. If, for instance, the type of event isn't unusual, the premiums to
insure will reflect substantial claims against the pool of insureds.

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B. What was the amount of loss before any insurance or other payment is considered? It
may differ from the amount of claim submitted (e.g., because of policy limits).

1. The amount of loss is the lesser of 1) decrease in fair market value (FMV) of the property
(value immediately before compared to value immediately after the event) or 2) adjusted
basis in the property. This rule applies both to business or investment property and to
personal-use property. Reg. 1.165-7(b)(1).

2. Decrease in FMV can be the cost to repair when repairs are actually made. Reg. 1.165-
7(a)(2)(ii). In practice, this is often the best evidence of the decrease, if it can be shown that
the property was restored to something very close to its pre-casualty condition.

During an unusual spring flood that qualifies as a casualty for tax purposes, A's basement fills
with water. In making repairs, she decides to do a major upgrade of a bathroom on that level.
The costs of the repairs, insofar as they restored the basement to its pre-flood condition, may
approximate what a hypothetical buyer of the property would demand as an allowance on the
purchase price, i.e., the decrease in fair market value. But the additional costs to upgrade the
bathroom cannot be used as part of the measure of decrease in fair market value, even if A's HO
policy covers the event and the adjuster finds a way to include those upgrade costs in the
payment on A's claim.

3. Basis is the "investment" in the property for tax purposes. Secs. 1011, 1012, and 1016.

a. Perhaps most commonly, basis is the cost to acquire plus costs of capital
improvements.

b. This cost amount can be reduced, if the property is used in a business or certain rental
activities, by depreciation deductions claimed to the date of the event. Depreciation for
tax purposes is a mechanism by which an estimate of the loss in utility or productive
capacity of an asset is deducted from its original basis over a period of years. The
number of years, and the portions of a particular asset's basis that is deducted in a given
year, are prescribed in the Code and Regulations for different types of assets. See, e.g.,
Sec. 167; Sec. 168.

NOTE: Where an asset that has been depreciated has been used in an activity (e.g.,
residential rental) which generates income subject to the net investment income (NII)
tax, computations to determine the amount of loss are the same as those for regular
income tax purposes. However, the alternative minimum tax (AMT) regime requires,
for some types of property, that different depreciation methods and lives be used. This
can result in a different amount of loss in determining the effect of the casualty or theft
in AMT income.

c. Basis can also be the basis of a transferor to the taxpayer, such as someone who gave
the property to the taxpayer as a gift. Sec.1015.

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A received a small fishing shack and shoreline lot on Lake Dyspepsia as a gift in 1998 from his
father B. The property was purchased by B in 1955 for $3,000, of which $1,500 was allocated to
the shack, and $1,500 to the land. The only capital improvement made to the property since then
was the addition of a boat shed in 1967, at a cost of $1,500. Today, A could sell the property for
at least $500,000, but his tax basis is only $4,500, ($3,000 structures, $1,500 land) i.e., the
donor's (B's) basis, his cost plus capital improvements.

4. SPECIAL RULE FOR DEMOLITION COSTS WHEN A STRUCTURE IS TOO

DAMAGED TO BE REPAIRED: Costs to demolish a structure or clear away rubble after a
fire or any other event that could generate a casualty loss do not increase the casualty loss.
Those costs must be treated as "capitalized" to (added to the investment in) the land on
which the structure formerly was located. Sec. 280B.

When a tornado runs directly over the house and lot owned by A, the house is so extensively
damaged that it is uninhabitable. To continue to live there, A has to build a new home on the
property from the ground up. She incurs $40,000 in demolition and removal costs to clear the
debris. That $40,000 expenditure doesn't increase any casualty loss that results from the tornado
damage. Instead, it has to be treated as an addition to her tax basis in the land.

C. Was the property used in a business or investment activity or was it used for personal
purposes?

COMMENT: The importance of this distinction will be more understandable after consideration
of the material in sections II.D, II.E and following. Here, note only the basic rule that all gross
income is subject to tax unless an exclusion is specifically provided in the law, and, conversely,
no deduction, exclusion or credit can be claimed without the same specific allowance. New
Colonial Ice Co v. Helvering, 13 AFTR 1180, 1182 (S. Ct. 1934).Tax benefits that are
perennially afforded to activity that seeks to generate income (business or investment) are not
necessarily afforded to activity that isn't purposefully directed to generating income. Quite
simply, Congress is more willing to subsidize activity that has a prospect of generating future tax
revenue.

1. Business or investment activity is generally any activity regularly carried on that is

directed to current or future economic profit. See, e.g., Doggett v. Burnett, 12 AFTR 505,
508 (D.C. Cir. 1933).

a. The terms "trade" and "business" aren't defined in the Code, but they can include
virtually all activities for profit or livelihood that require time, labor and attention. Flint
v. Stone Tracy Co., 3 AFTR 2834, 2849 (S. Ct. 1911). One activity doesn't have to
consume all an individual's time, labor and attention. The activity doesn't need to be
that person's principal activity, either, to be treated as a trade or business. Joseph M.
Philbin, 26 T.C. 1159, 1165 (1956).

b. The distinction between profit-seeking activity in a trade or business and that in an

investment context does not affect the computation of a casualty loss or gain per se. It
may be important for purposes of the new net investment income (NII) tax (see section

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 I.E.3, below). Where the distinction relates to the use of property, it often concerns the
seeking of long-term gain as opposed to seeking short-term profit. Moller v. United
States, 52 AFTR 2d 83-6333, 83-6336 (Fed. Cir. 1983). Another key distinction is the
presence of a regular, continuous, sustained activity (trade or business) as opposed to
isolated transactions (investment). Charles E. McManus, III, T.C. Memo 1987-457, 87-
2419.

Intending to hold it only for long-term appreciation, A buys a mint-condition vintage jukebox at
a collectors' convention. She immediately places the jukebox in storage. Alas, there is a break-in
at the storage facility, and A's jukebox is stolen. Assuming any and all insurance recoveries are
less than A's basis in the jukebox, A has a theft loss to investment property. The loss will reduce
A's other investment income for the year of the theft, for purposes of the NII tax.

Instead, assume A installed the jukebox for customer use in a 50s-theme restaurant that she owns
and manages, and it is stolen. If the insurance recovery is less than A's basis in the jukebox, the
theft loss will reduce A's other operating income from the restaurant. But, because running the
restaurant is a trade or business for A, the loss will not affect her NII tax.

2. Personal use property is everything else.

3. With part business use, part personal use property, the tax basis must be allocated
between the two components. Reg. 1.165-7(b)(4)(iv).

D. If the reimbursement is less than the total amount of loss, the difference is a casualty or
theft loss for tax purposes, potentially deductible. Reg. 1.165-7(a).

1. In general, a loss from a casualty is deductible under Sec. 165(c). Insurance

reimbursement (and, potentially, any other reimbursement) reduces the amount of the loss.
Sec. 165(a), Reg. 1.165-1(c)(4).

2. If the loss resulted from a casualty or theft involving only business or investment
property, insurance reimbursement is usually the only adjustment to arrive at the net
deductible amount. Certain further adjustments that are required with a loss involving
personal use property (see below) are not made. Deduction is allowed via Sec. 165(c)(1).

A mower used in a A's lawn care business (basis $1,600, FMV $1,500) is stolen. A recovers
$1,400 as a result of his claim against his Business Owner Policy (BOP). The casualty loss is
$1,500 (lesser of basis or decrease in FMV) less the $1,400 BOP payment, or $100.

3. A personal casualty loss, after being adjusted for any insurance reimbursement, is subject
to two further reductions to arrive at the amount ultimately deductible. Sec. 165(h).
Specifically, these reductions are

a. $100 for each event that constitutes a casualty or theft, and

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 b. the "floor", equal to 10% of adjusted gross income, which is subtracted from the
aggregate amount of all casualty and theft losses during the year.

A's Blue Streak speedboat (basis $60,000, FMV $35,000) is stolen by drunken yahoos and totally
destroyed when they run it over Perdition Falls, convinced that they can fly. The boat was used
solely for personal recreation, and A had no insurance covering the loss. His tentative casualty
loss is $35,000 (lesser of basis or decline in FMV). His adjusted gross income for the year of the
loss - a year in which he has no other casualties - is $250,000. A's deductible casualty loss is
$35,000 less $100 per-event subtraction less (.10)($250,000) floor, or $9,900.

4. SPECIAL RULE FOR PERSONAL CASUALTY LOSSES: The above scenarios assume
that a payment has been made as a result of a claim against an insurance policy. But the
potential deduction discussed in this section can be lost by failure to file a claim. If the
property was used for personal purposes, and no claim is submitted, no deduction is allowed
for the portion of the loss that would otherwise be covered by insurance. Sec. 165(h)(5)(E).

A's personal use car is damaged when a tree "jumps out and bites it". His tentative casualty loss,
assuming that he had no insurance, would be $8,000. However, A does have insurance, and he
could recover $7,000 if he filed a claim. A doesn't file a claim for the loss, because he worries
that, if he does, his premiums will be much increased for many years to come. A's tentative
casualty loss is reduced by this $7,000 that he otherwise would recover.

5. IMPORTANT TIMING ISSUES: A casualty loss deduction is allowable, assuming all

other requirements are met, in the year that the loss is sustained. Sec. 165(a). But the amount
claimed as a deduction must be reduced by any reimbursement for which there is a
"reasonable prospect" of recovery. Reg. 1.165-1(d)(2)(i). That often requires an estimate,
because the year a loss is sustained may not be the year in which insurance reimbursement is
ultimately received.

a. When an estimate of what's recoverable is used in claiming the loss on a return filed
for the year in which the loss is sustained, and that estimate turns out to be wrong in a
later year, the difference may need to be included in income, or deducted, depending on
the direction of the error. See, e.g., Sec. 111(a); Reg. 1-165-1(d)(2)(iii).

b. For this reason, when a claim is pending at the time the return for the loss year is due
(normally April 15 of the next year), the prudent course of action is to apply for an
extension of time to file. "Always extend, never amend" is a motto that everyone in tax
practice learns early on. Of course, payment of any balance estimated to be due (based
on the best information then available) should be made by the return's original due date,
to avoid late charges.

E. If the reimbursement is more than amount of loss there is a casualty or theft gain that
must be recognized for tax purposes. Sec. 1001(c).

1. Damages received for injury to capital (property interests) are excluded from income only
to the extent of the basis in the capital. Thus, where insurance reimbursement exceeds the

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 adjusted basis of the property destroyed in the casualty (or a component of the property if
that can be isolated, and the whole property isn't totally destroyed), that excess amount is a
gain includible in income. Sec. 1001(a). See further discussion of this principle at section
V.A, below.

2. How could this happen? Here are a few typical situations:

a. The basis of a home could be low because the property was purchased many years
ago, or received as a gift (donor's basis transfers to donee), or depreciation had
previously been claimed for business use of a portion of the home.

b. An auto's basis could be reduced via depreciation, either claimed directly or through
the standard mileage rate. Notice 2013-80, Sec. 3, 2013-52 IRB. Rev Proc 2010-51,
Sec. 4.04, 2010-51 IRB. The standard mileage rate is an estimate of the total, average
per-mile operating costs of a vehicle, allowed as a deduction to simplify recordkeeping,
in various situations where passenger autos are used for business. For instance, the 2013
standard mileage rate for business use of an auto is 56.5 cents per mile. Notice 2012-72,
2012-50 IRB 673.

A bought a minivan in 2009. While it was primarily a personal use vehicle, he did considerable
driving for business, and he claimed the standard mileage rate (cents per mile) deduction on his
tax returns for this use. The depreciation deemed to have been claimed as part of this per-mile
deduction for his business use (as determined in annual notices published by the IRS) was as
follows:

Rate per Mile

20122013 $.23
2011 .22
2010 .23
20082009 .21

A's basis in the car at the end of 2013 will be its cost, reduced for each year's standard mileage
rate deduction by the above rate times the number of business miles claimed.

c. With business personal property of various kinds including autos, both depreciation
and certain credits that reduce basis could have been claimed.

3. POSSIBLE ADDITIONAL TAX COST: For tax years beginning after 2012, a new net
investment income (NII) tax is imposed on non-business gains (as well as portfolio type
income, rents and other items not addressed in this material) of certain taxpayers. For
individual taxpayers, it can apply where those gains are includible in gross income for
regular tax purposes, and "modified adjusted gross income" (as defined) exceeds certain
threshold amounts ($250,000 for married individuals filing jointly, $125,000 for married-
separate filers, $200,000 for all others). Sec. 1411(a). The tax is in addition to regular
income tax and (if applicable) alternative minimum tax. It is imposed at a flat rate of 3.8%.

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 Id. Deductions associated with income subject to the tax, to the extent that they are
allowable for regular tax purposes, can reduce that income. Sec. 1411(c)(1)(B).

When A's lake cabin (purely a personal use dwelling) is damaged in a fire in 2014, his dwelling
fire insurance claim results in a net casualty gain of $4,000. He is otherwise subject to the NII tax
for this year because he has substantial gross income, consisting mainly of investment income.
None of his otherwise allowable deductions for the year are associated with the casualty gain.
Thus, the NII tax will apply to the entire $4,000, adding $152 ($4,000 x .038) to whatever he
owes with respect to that tax.

F. If there's a gain, will the activity be continued by reinvesting the proceeds of the claim?
If so, should the gain be deferred by making an election under the involuntary conversion
rules?

1. An "involuntary conversion" includes, inter alia, partial or complete destruction, or theft,

of property. Sec. 1033(a). This is an area where the Code provisions for casualty and theft
losses and involuntary conversions overlap.

2. Deferral isn't required; an election must be made with the return for the year the gain is
realized, i.e., the year payment is received. Reg. 1.1033(a)-2(c).

a. To the extent the payments received for the claim are reinvested in property "similar
or related in service or use" (essentially, performs the same function in the particular
activity) to the damaged/destroyed property, no gain is recognized.

b. Gain is recognized to the extent the payments are not reinvested. Sec. 1033(a)(2)(A).

4. The deadline for reinvestment to defer tax is 2 years after the close of the year in which
the first payment on any recovery is received, or later, if application is made to and
approved by Secretary of Treasury (IRS, as the designate for this purpose). Sec.
1033(a)(2)(B). One effect, and a possible reason for this relatively long period, is to avoid
forcing a recovering enterprise to make injudicious purchases under pressure of short
deadlines.

5. The quid pro quo for tax deferral is that the basis in the new "reinvestment" property is
reduced by the amount of gain deferred. Sec. 1033(b)(2).

The payment A receives on a claim under his building and personal property coverage (BPP)
policy, for destruction of a storage building in a fire, is $400,000. His basis in the property at the
time of the fire was only $320,000. A would have a casualty gain of $80,000 for the year in
which the fire occurred, but business is good and he wants to expand. He invests the entire
$400,000, plus another $50,000 of available cash, in a new storage building. If he chooses, A can
recognize the $80,000 gain on his return for the year of the fire. His basis in the building will
then be $450,000. But he can also elect to defer the gain, because he used all of his insurance
recovery to invest in similar property that will serve the same function in his business. If so, his
basis in the building will be $450,000 less the $80,000 deferred gain, or $370,000.

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COMMENT: The reason to forgo a deferral opportunity, and incur tax liability in the current
year, is the likelihood that the tax cost will be greater if the income is recognized in a future year.
For instance, there may be an expiring credit available in the current year, or an unusual loss or
deduction that will not recur. Or it may be substantially certain that the gain will have to be
realized in a particular future year when other income will be higher than in the current year,
pushing the taxpayer into a higher bracket.

G. Is there an opportunity to permanently exclude the casualty gain (up to a statutory

limit) because the property is the taxpayer's principal residence?

1. This opportunity will present itself if there's a total destruction of a residence in a fire,
flood, or other casualty. Where insurance or other payments exceed the taxpayer's basis in
the property subject to the casualty, the gain is treated as a gain on the sale of the property.
Sec. 121(d)(5)(A). This invokes the special rules for exclusion of gain on the sale of a
principal residence under Sec. 121. A taxpayer who qualifies will be able to exclude up to
$250,000 (or $500,000 for married-joint filers) of gain.

2. If the vacant land where the home was located is sold as a result of the casualty, the rule
allowing gain exclusion may apply to the aggregate of insurance proceeds and sale proceeds
on selling the underlying land. The involuntary conversion rules may even apply to gain in
excess of the excludable amount. Sec. 1033(d)(5). Rev. Rul. 96-32, 1996-1 CB 177.

COMMENT: The key point here is that permanent exclusion can apply up to the gain limit,
whether or not there's reinvestment in a principal residence. Additional gain can be deferred, but
only if there's reinvestment.

3. This exclusion, like the deferral under the involuntary conversion rule (above) is elective,
not required. Sec. 121(f).

A's principal residence is totally destroyed by a tornado. She purchased the home over 20 years
ago, and her basis in it immediately before the fire was $130,000. She receives $200,000 from
her HO insurance claim. She has a casualty gain of $70,000. However, if she qualifies, she may
elect to exclude the gain under Sec. 121, and she will not be required to include any of that
$70,000 in her income for the year of the casualty. Nor will she be required to purchase any
replacement property, or rebuild on the now vacant land.

H. If the loss involved the taxpayer's principal residence, was part of the total payment for
temporary living expenses?

1. Amounts received under a policy for the increase in living expenses caused by a forced
relocation due to damage or destruction of one's principal residence are excludible from
gross income. This includes the living expenses of the policyholder and members of his or
her household. Sec. 123(a). Reg. 1.123-1(a)(1) and (a)(2).

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 2. Only the excess of "reasonable and necessary" actual living expenses in the temporary
location over "normal" living expenses in the home qualifies for this exclusion. Temporary
living expenses for this purpose is a net calculation, i.e., savings on one element, such as
utilities, are netted with added costs on another, such as meals. Anything received for
temporary living expenses beyond that excess amount is includible in gross income. Reg.
1.123-1(b)(1), (b)(2) and (b)(3).

After a fire damages their home, A and his family relocate to a hotel for three weeks while
repairs are being done. Their normal living expenses for that time would be $3,000. Their living
expenses in the hotel amount to $4,000. The family's increase in living expenses is $1,000. If A
receives a $1,200 payment under his HO policy for temporary living expenses during the repair
period, only $1,000 of that amount is excludible from his gross income. The balance ($200) must
be included in his gross income.

3. This rule applies to principal residences that are rented as well. Reg. 1.123-1(c).

In the example immediately above, if A and his family lived in a rented home, and they had a
renter's insurance policy that provided temporary living expense coverage, the very same result
would obtain.

III. Property damage claim paid by another party's HO, auto,

property/casualty or commercial general liability coverage

A. Is part of payment under the policy for something other than the property damage itself,
such as interest, punitive damages, or income loss from the property's damage or
destruction? Isolate those parts if possible.

1. For the portion of the total amount paid that is measured by the property damage or loss,
the analysis is the same as in section II, above.

2. The portion of the total payment based on lost earnings resulting from inability to use the
property is generally includible in gross income. See section V, below, for further discussion
of the distinction between injury to an asset that produces income and loss of the income
itself.

3. The portion of the total payment representing interest, i.e., compensation for delay in
making the payment, is includible in gross income. Sec. 61(a)(4). If the recipient is
otherwise subject to NII tax in the year of receipt, the interest portion will be part of NII
taxable income as well. Sec. 1411(c)(1)(A)(i).

4. Any portion of the total payment arising from a judgment allocated to punitive or
exemplary damages is includible in gross income. This is the case for judgments in property
damage as well as personal injury actions, because such damages are not intended as
compensation for injury, whether to property or to person. They go beyond the purpose for
which Congress intended that an exclusion be granted - to "return the victim's personal or

10
 financial capital. Thus, no exclusion provision applies. O'Gilvie v. United States, 78 AFTR
2d 96-7454, 96-7457-60 (S. Ct. 1996).

5. When a settlement agreement clearly allocates proceeds to components having different

taxability, the allocation is not binding upon the Tax Court. It should, however, receive
"proper regard" to the extent that the agreement is entered into by the parties in an
adversarial context at arm's length and in good faith. Robinson, Edward E., 102 T.C. 116,
127 (1994), affd on this issue 76 AFTR 2d 95-7786, 95-7788 (5th Cir. 1995).

B. What if nothing is specified in a written settlement agreement or any other document

about the allocation?

1. The origin and nature of the claim that produces a settlement controls its allocation to
various components where a single, unspecified payment is received. This is a question of
fact, and the taxpayer must produce evidence sufficient to support any allocation, or risk
being taxable on the entire amount. Knuckles v. Commissioner, 16 AFTR 2d 5515, 5517
(10th Cir. 1965).

2. The IRS or other taxing authorities can make a re-allocation and assert a deficiency if the
taxpayer doesn't offer adequate support for his or her tax return position. Such an allocation
enjoys a presumption of the correctness. Welch v. Helvering 12 AFTR 1456, 1457 (S. Ct.
1933). The taxpayer in such a case has the burden of proving, by a preponderance of
evidence, that the IRS' determination is erroneous. Griffin v. Commissioner, 91 AFTR 2d
2003-486, 2003-490 (8th Cir. 2003); Estate of Reinke v. Commissioner, 95 AFTR 2d 95-
736, 95-738 (8th Cir. 1995); Tax Court Rule 142(a).

NOTE: as a result of a 1998 enactment, the burden may be shifted to the IRS on purely
factual issues when a taxpayer introduces "credible evidence" on those issues, if certain
other criteria are met. Sec. 7491(a). While the rule is potentially important in close-facts
cases, the ultimate burden of persuasion would nonetheless remain with the taxpayer. And
questions of law, or mixed questions, are not affected.

3. The complaint itself, and the opinion and orders of the court in a prior trial, should be the
departure points for determining the character of the later settlement payment. Ray v. United
States, 69 AFTR 2d 92-953, 92-957 (Cl. Ct. 1992).

a. There can be a punitive damages portion of the ultimate payment even if the final
disposition isn't made by a tribunal. A jury verdict that provides an allocation is
normally the best indicator of the breakdown, even if a subsequent settlement
agreement made in the course of an appeal is silent. Bagley, Hughes, 105 T.C. 396, 410
(1995), affd on this issue 80 AFTR 2d 97-5739, 97-5741-42 (8th Cir. 1997).

b. If pecuniary (liquidated) damages are determined in a prior trial and judgment, and
prejudgment interest is involved, a later settlement which is silent about components
can nonetheless be viewed as including interest. Rozpad v. Commissioner, 82 AFTR 2d
98-5840, 98-5843 (1st Cir. 1998).

11
Recommended reading in this context, and equally applicable to other types of settlements
discussed in this material, is the IRS' Lawsuits, Awards, and Settlements Audit
Techniques Guide (2011), available at http://www.irs.gov/pub/irs-
utl/lawsuitesawardssettlements.pdf.

IV. Personal injury claim

COMMENT: Regardless of whether any part of a payment arising from a personal injury claim
is subject to regular income tax, it will not be subject to the new net investment income tax
unless it is interest. NII is composed of items that fall into listed categories in Section 1411(c)(1).
There is no "including, but not limited to...." language. The categories are apparently exclusive,
and the final Regulations make no attempt to add others. See Reg. 1.1411-4(a)(1).

A. Is the payment based on physical injuries, pain and suffering?

1. A taxpayer generally may exclude from gross income the amount of any damages
received on account of a personal physical injury or physical sickness.

a. This exclusion applies whether the damages amount is received by prosecution of a

suit or by any kind of agreement in lieu of a suit, and whether as a lump sum or as
periodic payments. Sec. 104(a)(2), Reg.1.104-1(c)(1).

b. If an action has its origin in physical injury or sickness, then all damages that flow
from that claim (other than punitive or exemplary damages) will generally be
excludible. H.Rept. No. 104-586 (P.L. 104-188), pp. 143-44.

Damages (other than punitive damages) received by A on account of a claim for loss of
consortium due to the physical injury or physical sickness of B, who is A's spouse, are excluded
from gross income.

2. Exclusion under this provision generally requires establishment of both

a. Prosecution or settlement of a claim based on tort or tort-type rights, and

b. Receipt of damages "on account of" personal physical injury or physical sickness. To
meet the "on account of" requirement, there must be a "direct causal link" between the
damages and the injuries sustained. Lindsey v. Commissioner, 96 AFTR 2d 2005-5959,
2005-5962 (8th Cir. 2005).

3. The requirement of "tort or tort-type" rights is broad enough so that the exclusion applies
even if damages for physical injury or sickness are received under a state statute, and even if
the injury is not a tort under the law. Thus, payments under no-fault statutes also qualify for
the exclusion. Reg. 1.104-1(c)(2).

12
 4. Damages for emotional distress are generally includible in gross income. There are only
two special cases where damages for emotional distress may be excluded. Sec. 104(a)(1),
Reg. 1.104-1(c)(1).

a. Pure tort damages for emotional distress are excludible from gross income if the
distress is directly attributable to physical injury or sickness.

b. Damages based on emotional distress, to the extent they reimburse outlays that would
qualify as deductible medical care are also excludible.

Reimbursement of medical expenses incurred to treat A's physical sickness, including insomnia,
headaches, and stomach disorders, that resulted from the emotional distress of witnessing a
particularly gruesome backyard barbecue explosion, are isolated as part of a settlement
agreement. This part of the total settlement can be excluded from A's gross income for the year
in which it is received.

5. As noted above, a settlement having an explicit allocation to a tax-free portion (for

physical injuries or sickness) and a taxable portion (for emotional injury or sickness not
arising from the physical injury), can be respected if it results from good faith, adversarial
bargaining. Robinson, 102 T.C. at 127.

6. In the absence of an express settlement agreement, the most important factor in applying
section 104(a)(2) to any payment " received by prosecution of a suit or by any kind of
agreement in lieu of a suit" is the intent of the payor in making the payment. Metzger v.
Commissioner, 88 T.C. 834, 847-848 (1987); Mitchell, Harry H., T.C. Memo 1990-617, 90-
3022. See also section V.A, below.

B. If part of the payment specifically reimburses medical expenses incurred by the

taxpayer/claimant, were any of those expenses deducted on a prior year's income tax
return?

1. Reimbursements of medical expenses (economic damages) as part of payments arising

from tort or tort-like claims are excludible from income in the same way that direct
compensation for pain and suffering is. Sec. 105(b).

2. But if there was a tax benefit derived by claiming the medical care expenses as deductions
in a prior year, the reimbursement, when received, will be includible in gross income. Sec.
111. Essentially, this is a no-double-dip rule. Congress was saying, you can't claim a tax
benefit from spending the money and then later have the money returned to you without a
corresponding tax detriment.

Because she believes that her claim for $40,000 that she paid for an out-of-network,
experimental medical procedure will not be covered by her health insurance, A deducts the entire
amount as part of her total medical expenses on her 2013 federal tax return. The entire amount is
deductible, and results in tax benefit, because she had substantial additional medical expenses
that were not covered that year. She submits a claim anyway. Unexpectedly, she is reimbursed

13
$30,000 under the policy for that claim in 2014. She must include the $30,000 in her 2014 gross
income.

V. Generalized approach to distinguishing taxable and nontaxable recoveries

for various claims grounded in tort, contract or both

A. What was the injury that gave rise to the claim?

1. The basic determinant of taxability for a wide variety of claims may be framed as follows:
Recoveries for lost or injured capital are excludible from income, to the extent of the tax
basis in the capital. Recoveries of lost profits are not. The test is "in lieu of what were the
damages awarded?" Raytheon Production Corp. v. Commissioner, 32 AFTR 1155, 1158 (1st
Cir. 1944).

Business A contracts with business B to do scheduled maintenance on B's widget machine. A

fails to timely perform critical tasks under the contract, causing damage to the machine and
forcing its shut-down. B's claim could involve both injury to capital (the machine) and lost
income (from inability to meet a deadline for a customer's widget order while the machine was
out of service).

a. The function of this origin-of-the-claim test is "to treat the amount as a substitute for
the item of loss and tax it in the same manner as if the loss had not occurred". PLR-
104389-07.

b. The underlying nature of the claim controls regardless of whether the taxpayer
effected collection amicably or by resolving a dispute through compromise or litigation.
Ray, 69 AFTR 2d at 92-957. It controls regardless of whether the claim is valid. Lindsey
v. Commissioner, T.C. Memo 2004-113, 723-24, affd in result 96 AFTR 2d 2005-5959
(8th Cir. 2005).

2. All the circumstances surrounding a settlement agreement, not just the recitations within
it, may be examined to discern the nature of the claim and, as a critical factor for this
purpose, the payor's intent. Lindsey, T.C. Memo 2004-113 at 723.

3. However, merely raising the issue of lost profits in litigation or settlement negotiations
will not automatically establish that such is the essential nature of the claim. Lost profits
may potentially be used solely as a measure of damage to capital (e.g., a trademark) without
altering the nature of the claim. Raytheon, 32 AFTR at 1158-59; Inco Electroenergy Corp.,
T.C. Memo 1987-437, 87-2295.

B. Injury to capital

1. The scope of the injury-to-capital exclusion extends to recoveries of outlays, even if non-
capital in nature, where the outlays were avoidable.

14
 a. Recoveries of excess costs to acquire capital, where the excess costs resulted from the
defendant's actions or errors, are excludible from income. Rev. Rul. 68-378, 1968-2
C.B. 335; Rev. Rul. 81-277, 1981-2 C.B. 14. A 3-element approach has been employed
by the IRS in its attempts to determine whether a particular recovery is taxable: (1) a
breach or criminal act occurred; (2) the act caused an impairment of capital; and (3)
reimbursement is based upon, if not measured by, the amount of lost capital. FSA 948,
Vaughn # 948.

b. Recoveries of excess costs other than for acquisition of capital as a result of the
defendant's actions or errors (e.g., overpaying tax as a result of an attorney's or
accountant's malpractice) are likewise excludible. Clark v. Commissioner, 40 B.T.A.
333, 335 (1939), acq. 1957-2 C.B. 4.

2. But, with other costs as well as with medical expenses (section IV.B, above), where the
costs that are recovered had previously been claimed as an income tax deduction, and tax
benefit was derived from that deduction, the recovery will be taxable. Garey A. Cosentino,
et ux. v. Commissioner, TC Memo 2014-186, 1316.

C. Lost income

1. Recoveries of lost profits are includible in gross income. Raytheon, 32 AFTR at 1158;
Sager Glove Corp. v. Commissioner, 36 T.C. 1173, 1180 (1961); Reg. 1.123-1(a)(3).

a. The significant exception to this rule, discussed above at section IV.A, is damages
received on account of personal physical injury or physical sickness. If the element of
lost wages in such damages, for instance, is no more than reimbursement for the period
of missed work due to personal physical injury, it satisfies the "on account of"
requirement. Commissioner v. Schleier, 75 AFTR 2d 95-2675, 95-2678 (S.Ct. 1995).

b. Where the IRS has determined that the transaction at issue gave rise to ordinary
income, this determination carries a presumption of correctness, as previously noted. A
mere assertion by the taxpayer that there has been an injury to goodwill (even where the
existence of the goodwill itself might be established) isn't sufficient to overcome that
presumption. Carter's Estate v. Commissioner 9 AFTR 2d 460, 462-63 (8th Cir. 1962)
(citing Goldsmith v. Commissioner, 22 T.C. 1137, 1144 (1954)).

c. Where the damages are based on a benefit-of-the-bargain theory, the IRS will treat
that as essentially the same as a recovery of lost income. A distinction is made between
injury to existing opportunities (e.g., the isolable goodwill of an ongoing business) by
tortious or criminal acts and the loss of an expectancy by failure of the other party to
perform under a contract. TAM 2004380380.

An anti-trust violation that forces a business to overpay for critical inputs is an injury to its
goodwill. A claim based on this injury, if successful, will result in a settlement found on injury to
capital. But a refusal of a target business to conclude a merger is a denial of a future opportunity,
and a settlement of a claim based on that act is treated as lost profits damages.

15
 2. An alternative theory may be used to determine that a settlement is ordinary income.
Where the taxpayer is unable to establish the existence of capital that has sustained an
injury, the taxable portion of any settlement payment will be ordinary since there has not
been a sale or exchange. If the claimant is compensated not for destruction of property, but
for unlicensed use of property, the operative principle will be that the obligor has received
nothing in exchange for its payment that can be transferred to another party. Nahey v.
Commissioner, 111 T.C. 256, 262-63 (1998), aff'd in result 84 AFTR 2d 99-7008 (7th Cir.
1999), cert. denied 148 L. Ed. 2d 15 (S. Ct. 2000).

VI. Life insurance

A. Is the contract a life insurance contract?

1. GROSSLY OVERSIMPLIFIED BACKGROUND ON THE LIFE INSURANCE

DEVICE: Life insurance is a risk-pooling arrangement that transfers the risk of untimely
death (when some other party is relying on the insured, i.e. has an "insurable interest") from
the individual to an actuarially structured group. This risk-shifting and risk-distributing
characteristic is essential to characterizing a contract as life insurance. Helvering v.
LeGierse, 25 AFTR 1181, 1184 (S. Ct. 1941).

a. Term life insurance is a product that provides only pure life insurance protection
during a period of time (normally a year). It becomes progressively more expensive for
all members of the group, because, as they age, a larger number of group members will
die during each successive policy period, and as a result more of the annual premium
revenue will need to be paid out as death benefits.

b. Thus, one of the most important reasons for the development of life insurance that
accumulates a cash value over the life of the insured is to allow for a level premium. By
charging each insured more than the cost of pure insurance during the early years in
which the policy is in force, the excess can be accumulated and invested. Thus it
develops a reserve to pay the larger number of claims that will be inevitable as all of the
insureds in the group age.

2. Sec. 7702 was added to the Code in 1984 to curb perceived abuses of the life insurance
form that led to a proliferation of products that functioned more like deposit accounts, even
though they were afforded two important tax benefits.

a. First, the earnings credited to life insurance policies, to the extent not withdrawn,
accumulate tax free. Sec. 72(e)(5)(A).

b. Second, death benefits under life insurance policies are also tax free. Sec. 101(a).

c. This new law added two actuarial tests, either or both of which must be met for the
entirety of a contract issued after December 31, 1984, in order for it to be considered
life insurance for tax purposes. Sec. 7702(b), (c) and (d). Both tests serve to limit

16
 qualifying contract types to those that provide only modest investment return, and
function primarily as risk pooling plans.

3. The point of this digression? Many, if not most, companies that offer products that qualify
as life insurance for tax purposes also offer other products. These other products have their
legitimate uses (e.g. annuities). But some will have features that may be perceived by the
client as death benefits, and confusion about the nature of a particular product is
understandable. Reading the actual contract is recommended, but because the tests of
whether a product is or is not life insurance require actuarial calculations, the ideal approach
is to request written assurance from the insurer that the contract at all times prior to payment
of the death benefit met the Code definition of life insurance in all respects.

A variable annuity may be sold with an additional-cost rider that allows increases in the values of
the investments under the contract to be "locked-in" periodically, setting a floor on the amount
that will be paid to the beneficiary on the death of the annuitant. This feature is often promoted
as a way to provide life-insurance-like protection for persons whose health or age makes them
ineligible for conventional life insurance. Unfortunately, the "death benefit" paid to the
beneficiary under such a contract is not treated as life insurance for purposes of the Sec. 101
exclusion.

4. And why does this matter? Because if a contract that meets the state law definition of life
insurance fails to meet the requirements to be classified as such for income tax purposes, the
death benefit is bifurcated. Sec. 7702(g)(2) and (g)(3).

a. Only the excess of the total death benefit over the cash-out value immediately before
death (the "net surrender value") is excludible from gross income. That amount is
treated as pure insurance protection.

b. The balance, i.e., the net surrender value, is treated as a commercial annuity would
be. In other words, any investment build-up included in the net surrender value that
previously escaped income tax becomes taxable, as ordinary income, when payment is
received.

COMMENT: Annuity taxation is beyond the scope of this material. An annuity contract can
offer tax deferral, but not complete tax exclusion - as life insurance does - for investment
earnings during its accumulation period. As noted above, no disparagement of annuities or any
other financial product is intended. A misunderstanding of the source of a payment occasioned
by someone's death, however, can cause a tax "blindside".

5. The fact that a payment made on account of someone's death is funded with life insurance
does not mean that payment retains its character as a life insurance death benefit when paid
to another party, even if that second payment would only have been made as a result of the
insured's death.

a. One common situation where this confusion can occur is with an employee death-
benefit plan maintained by an employer. Payment to a survivor from an established

17
 employer plan maintained for the purpose of paying survivor benefits is not a life
insurance death benefit. It is additional compensation income of the decedent, taxable to
the survivor. Simpson v. United States, 2 AFTR 2d 6036, 6040-41 (7th Cir. 1958);
Essenfeld v. Commissioner, 11 AFTR 2d 303, 304-05 (2nd Cir. 1962).

b. Another common use of life insurance is to provide cash for the purchase of a
deceased business owner's share of the business. Whether the death benefit is payable to
the business itself, or to one or more surviving co-owners, it may be treated as life
insurance to the recipient(s), but the subsequent payment to the decedent's successor
(who was not the beneficiary under the policy) in exchange for the business interest is
treated as a separate transaction, regardless of the source of the funds for the payment.

B. Was the payment under the policy made because of the death of the insured?

1. The general rule is that amounts received under a life insurance contract (whether in one
sum or in a series of payments) are not part of reportable gross income when received by
reason of the death of the insured. Sec. 101(a).

2. If a death benefit is received over a period of years, it will normally include interest. Even
though the death benefit is not includible in gross income, the interest will be includible.
Sec. 72(j). In addition, if the recipient is subject to NII tax, the interest will be part of NII
taxable income. Sec. 1411(c)(1)(A)(i).

When A dies, his spouse B is the beneficiary of a life insurance policy on A's life, having a
$100,000 death benefit. The benefit is payable either as a lump sum, or over a period of years. B
chooses to have the benefit paid over a period of years. The first payment, $10,300 consists of a
$10,000 portion of the death benefit and $300 interest. B's gross income for the year must
include $300 of interest, but none of the $10,000 death benefit is includible in gross income.

3. Payment received because of a surrender of a life insurance policy that provides a cash
value portion is not "by reason of the death of the insured".

a. If an amount is received under a life insurance contract on the complete surrender,

redemption, or maturity of the contract, Sec. 72(e)(5)(A) requires that the amount be
included in gross income, but only to the extent it exceeds "investment in the contract."
Income from surrender of a life insurance contract is ordinary; it is not capital gain.
Rev. Rul. 2009-13, 2009-21 IRB 1029.

b. Investment in the contract as of a given date is the aggregate amount of premiums

or other consideration paid for the contract before that date, less the aggregate amount
received under the contract before that date, to the extent that amount was excludable
from gross income. (The most common type of excludable amounts is probably loans
against policy cash values.) Sec. 72(e)(6).

A receives $78,000 on the complete surrender of a life insurance contract. He had paid aggregate
premiums of $64,000 on the contract, and had never received any distributions under the

18
contract, nor borrowed against its cash value before surrender. Thus, A's investment in the
contract was $64,000. As a result, A must recognize $14,000 of ordinary income on surrender of
the contract ($78,000 $64,000).

C. Was the policy ever transferred for any "valuable consideration"?

1. The complete exclusion of a death benefit paid under a life insurance policy will not apply
if the policy was ever the subject of an absolute transfer, for value, of a right to receive all or
part of the proceeds of the policy. Sec. 101(a)(2); Reg. 1.101-1(b)(4).

a. The transfer must be a total relinquishment of rights, not merely a pledge or

assignment of a policy as collateral, of the entire contract or "any interest therein". Id.

b. There must be an actual transfer of valuable consideration (i.e., mere recitation such
as "for one dollar and other valuable consideration" without a transfer will not trigger
the rule). But any consideration that could support an enforceable contract will suffice,
if actually transferred. The interdependence of two parties' separate actions or promises
may also be at issue.

c. A transfer for value can occur even if the subject policy has no cash surrender value
(i.e., it is a term policy). James F. Waters, Inc. v. Commissioner, 35 AFTR 1011, 1012
(9th Cir. 1947).

2. If there has been a transfer for value, the exclusion from gross income applies only to the
value of the consideration paid by the transferee to acquire the contract (or interest in it),
plus any premiums or other amounts paid by the transferee after the transfer. Sec. 101(a)(2).
"Other amounts" means non-deductible interest paid on borrowing to acquire the contract or
interest in it. Id.

B pays $500 for an insurance policy upon the life of A, naming himself as beneficiary. B
subsequently transfers the policy to C, who is made beneficiary, in exchange for $600. C
receives $1,000 in death benefits under the contract when A dies. However, C can only exclude
$600 from her gross income, because that is the amount of consideration she paid for the policy,
assuming there were no post-transfer premiums or other amounts paid by her. (Adapted from
Reg. 1.101-1(b)(5), Ex 1.)

3. There are five exceptions to the transfer for value rule. If a life insurance policy is
transferred and the transfer falls within one or more of the following exceptions, then the
death benefit will not be subject to income tax. The exceptions are:

a. A transfer in which the transferees basis is determined in whole or in part by

reference to the transferors basis (the carry-over basis exception - perhaps most
commonly, the gift of a policy). Sec. 101(a)(2)(A).

19
This exception must be approached with some caution. Any tacit understanding that the donee
will do anything or provide anything susceptible of valuation in return can taint the gift, if that
understanding is acted upon.

b. A transfer to the insured. Sec. 101(a)(2)(B).

c. A transfer to a partner of the insured. Id.

d. A transfer to a partnership in which the insured is a partner. Id.

e. A transfer to a corporation in which the insured is a shareholder or officer. But note,

this exception does not apply if the insured is only a director; nor does it apply to a
transfer to a co-shareholder. Id.

Z Corporation assigned a life insurance policy it had taken out on A to N corporation, in which A
is a shareholder. The N corporation can exclude from its income the entire death benefit it
receives under the policy when A dies. Since A is a shareholder in N Corporation, the fact that Z
Corporation received some valuable consideration for the assignment is ignored, and the general
rule excluding life insurance death benefits still applies. (Adapted from Reg. 1.101-1(b)(5), Ex
5.)

4. OPPORTUNITY TO CURE: The taint of a transfer for value can be eliminated by a later
transfer - but before the death of the insured - to the insured or another exempt party. Reg.
1.101-1(b)(5), Ex. 7. Also, a taxpayer can transfer a life insurance policy to his or her spouse
or former spouse incident to divorce, without subjecting the proceeds to income taxation.
Sec. 1041.

5. UNCERTAINTY REGARDING NII TAX: Is the portion of a life insurance death benefit
which is taxable because of the transfer-for-value rule subject to the Sec. 1411 net
investment income tax? It seems very likely to be. Reg. 1.1411-4(a)(1)(iii) provides that
gain from the disposition of non-business property is generally subject to the NII tax. Reg.
1.1411-4(d)(1) defines "disposition" for this purpose to include "cash settlement". Further,
Reg. 1.1411-4(d)(3)(i) includes in gain or loss from property dispositions " ... gain or loss
attributable to .... disposition of a life insurance contract.." See also Rev. Rul. 2009-14,
2009-21 IRB 1031, Situation 1, generally discussing the character of a life insurance
contract acquired by purchase, and the character of includible gross income upon receipt of
its death benefit.

VII. Legal fees incurred by the taxpayer to collect the insurance payment
COMMENT: The likely follow-up question to "Is this payment taxable?" is, of course, "Is your
legal fee deductible?" Unfortunately, even if the answer to that second question is yes, the
question which ought to be asked is "Will your legal fees get me any tax benefit?" The manner in
which the fees are deducted, i.e., the placement of that deduction amount in the calculation of
taxable income, determines whether, and how much, tax benefit may be realized. The following
material provides no more than a hint of the complexity of this topic.

20
A. How much detail can be obtained about the specific tasks generating the legal fee?

1. Costs incurred to collect non-taxable income can't be deducted. Sec. 265(a)(1). Reg.
1.265-1(b)(1). Reg. 1.212-1(e).

2. Thus, where the payment will be partially taxable, analyze the legal fee paid, if possible,
to identify its components. Use a reasonable proration if necessary. Reg. 1.265-1(c).

In a personal injury action, A is awarded by a jury, and ultimately receives, $200,000 for his
uninsured medical expenses and physical pain and suffering (nontaxable) and $100,000 for
punitive damages (taxable). If A's legal fee cannot be broken down into amounts directly related
to each part of the award, and if A claims an income tax deduction for 1/3 of the total fee, that
should be considered a reasonable allocation.

3. The origin and character of the particular claim determines how legal fees incurred to
prosecute the claim may be deducted, if at all. This is a factual determination requiring
analysis of all circumstances surrounding the claim. To that end "....the fact finder must take
into account, among other things, the allegations set forth in the complaint, the issues which
arise from the pleadings, the litigation's background, nature, and purpose, and the facts
surrounding the controversy." Guill v. Commissioner, 112 T.C. 325, 329 (1999).

B. Were the legal fees incurred to obtain recompense for an event that resulted in the
damage to property? If not, will the recovery include taxable income?

1. Costs of collecting a claim for damage to property are treated as reducing the amount of
insurance recovery. That increases the amount of loss that is potentially deductible, or
reduces the amount of a casualty gain. Spectre, Harry, T.C. Memo 1966-97, 66-581, 66-586.

2. Costs incurred by an individual to collect income that will be taxable when received may
be deducted directly from that income, provided the income is connected with a trade or
business. For example, legal fees may be deducted directly from the associated recoveries
that are part of the gross income of a sole proprietorship business. This includes any fees
allocable to punitive damages that are part of that business income. Guill, 112 T.C. at 331-
32.

3. However, costs incurred by an individual to collect income that will be taxable when
received, but not connected with a trade or business, may receive less favorable tax benefit.
Such costs must generally be treated as "miscellaneous deductions", a category of itemized
deductions. Sec. 212(a), Reg. 1.212-1(a) and (k).

a. The Supreme Court settled uncertainties about this treatment in contingent fee cases,
by determining that the rule applies to such fees as well. Commissioner v. Banks, II, 95
AFTR 2d 2005-659, 2005-665 (S. Ct. 2005).

21
 b. Where a claim results in receipt of a taxable non-business gain, interest, or both, and
the taxpayer is subject to the NII tax in the year of receipt, then a portion of the fee can
be deducted against that income in arriving at NII taxable income. The deductible
portion, however, will be adjusted for regular income tax limitations applicable to
miscellaneous itemized deductions. Sec. 1411(c)(1)(B); Reg. 1.1411-4(f)(3)(ii).

c. Exceptions that allow legal fees to be deducted in arriving at adjusted gross income,
rather than as itemized deductions, are provided for fees paid to collect claims falling
within enumerated federal laws under Sec. 62(e) via Secs. 62(a)(20) and 62(a)(21) -
generally laws addressing employment discrimination, whistleblower or False Claims
Act issues. However, the deduction is limited in each case to the amount that the
taxpayer must include in gross income.

A, a film star, receives a settlement payment of $100,000 in an action against a photographer for
emotional distress caused by constant intrusions into her personal life. Her legal fees incurred to
collect the settlement are $25,000. Because the settlement is damages solely for emotional, not
physical, injury, the entire $100,000 is includible in her gross income. It cannot be reduced by
the $25,000 legal fees she paid. Instead, the legal fees will be part of her miscellaneous itemized
deductions. Even if she has no other income for this year, $2,000 of her deduction will be lost,
because miscellaneous deductions are generally subject to an arbitrary subtraction ( a "floor") of
2% of adjusted gross income (here, it would be $100,000 x .02, assuming there was absolutely
nothing else included in her adjusted gross income). Worse, if A is subject to alternative
minimum tax (beyond the scope of this material), the deduction will be entirely lost for purposes
of that computation.

22
SIMPLIFIED RELATIONSHIPS OF INCOME AND DEDUCTION ITEMS USED TO ARRIVE AT THE TAX BASE IN
THE 3 INCOME TAX REGIMES AFFECTING INDIVIDUALS

NET INVESTMENT "REGULAR" INCOME ALTERNATIVE

INCOME TAX TAX MINIMUM TAX

Income item 1
Some of the Income item 2 Most of the
regular tax Income item 3 regular tax
income items Income item 4 income items
(etc.) without adjustment
___________________ + addtional items
Gross income
One possible + adjustments Some of the same
- adjustment - adjustments and some different
____________________ adjustments
Adjusted gross income
-itemized deductions
- Some deductions (medical, taxes, interest - Some deductions
related to above casualty/theft losses, (but notably not
income other "miscellaneous") taxes or miscellaneous
OR deductions)
-standard deduction (no standard deduction)
_____________________
Subtotal -completely different
(no exemption) -exemption(s) exemption

_____________________ _____________________ _____________________

TAXABLE INCOME TAXABLE INCOME TAXABLE INCOME
X 3.8% - APPLIES ONLY IF SUBJECT TO MULTIPLE-TIER SUBJECT TO 2-TIER TAX
REGULAR TAX INCOME, AS TAX RATE SCHEME RATE SCHEME
ADJUSTED, IS > THRESHOLD
ADDITIONAL TAX, IF IT APPLIES ULTIMATE LIABILITY IS THE GREATER OF THESE TWO TAX AMOUNTS
Robert E. Lynn, JD, CPA, CFP has over thirty years' experience in tax matters affecting
closely held businesses, fiduciary entities and individuals. A disastrous insurance gap was
actually a major reason for this career choice. In the late seventies, he was working as an editor
for a reference book publisher in New York City, when a warehouse fire destroyed virtually the
entire stock of its best-selling titles. Important bulk orders could not be filled, and the company
had no business interruption insurance, so the downsizing began. Bob survived the staff cuts, but
he found himself pinch-hitting in accounting and payroll. He took night courses in accounting,
eventually earning an accounting degree from Baruch College. By the mid-eighties, he was on
staff at a medium sized CPA firm, where he earned his initial licensure.

Bob repatriated to the Twin Cities in the early nineties, earned the Master of Business Taxation
degree at the University of Minnesota, and worked most of that decade and the next as a tax
manager for the CPA firm Johnson, West in Saint Paul. But then three years as a tax specialist at
Lindquist & Vennum convinced him to change course. He was admitted to the Minnesota Bar in
May of 2014, and shortly thereafter formed Bartley & Lynn, LLP with Charles Bartley, another
Hamline Law alum and CPA, to focus on tax, trust and estate matters.

Bob has represented numerous clients in audits and appeals within the IRS and Minnesota
Revenue. He has presented seminars for Minnesota CLE, the Minnesota Society of CPAs and
various community groups, and taught income tax planning at Minnesota State University. His
national journal publication credits include articles in Tax Notes, Practical Tax Strategies, and
The Tax Adviser. He has also been trying for years, without much success, to be less of a
pushover for pro bono work for small arts organizations.