Money received by client due to attorney malpractice wasn’t gross income!!

In a private letter ruling, IRS has held that where a taxpayer lost a nonbusiness wrongful death lawsuit, then sued his insurance company and law firm for malpractice with respect to their handling of the wrongful death case, the amount he received from winning the malpractice suit was deemed a return of capital to compensate for a loss and thus was not gross income.

Background. Gross income includes all income, from whatever source derived. (Code Sec. 61(a)) This broad definition is generally interpreted to include all accessions to wealth, and exclusions from income are narrowly construed. (Schleier, (S Ct 1995) 75 AFTR 2d 95-2675)

Payments are excludable from gross income as a return of capital if they are to compensate for the loss or destruction of capital. A taxpayer bears the burden of showing entitlement to this exclusion. (Milenbach, (CA 9 2003) 91 AFTR 2d 2003-818, affg on this issue Milenbach, (1996) 106 TC 184)

Facts. Taxpayer is a bankruptcy estate. Taxpayer was created in response to an unfavorable judgment against Insured, who fatally injured a party with his automobile. Insured was covered by an automobile insurance policy.

A wrongful death law suit was instituted by the fatally-injured party’s family (“victim’s family”) against Insured and Insured’s automobile insurance company (“Insurer”). Insured was represented by Insurer’s law firm (“Law Firm”) in defending the wrongful death law suit. Law Firm failed to settle the lawsuit within the policy limits of the automobile policy.

The victim’s family went to trial against Insured and Insurer. After trial, a significant judgment was granted against Insured. Insured then filed for bankruptcy.

The only asset of significance Taxpayer obtained from Insured was a legal claim against Insurer and Law Firm. The legal claim was that Insurer and Law Firm failed to settle within the policy limits, exposing Insured to the large personal judgment. Taxpayer instituted a lawsuit against Law Firm and Insurer, alleging various errors, including professional negligence by Law Firm (“malpractice lawsuit”).

The parties to the malpractice lawsuit executed a settlement under which Taxpayer would receive a substantial payment from Law Firm’s malpractice insurer (“Settlement Payment”). There were no punitive damages. The settlement was approved by the bankruptcy court.

At issue in the PLR is whether Taxpayer can exclude the Settlement Payment from its income.

Settlement payment isn’t gross income. The PLR concluded that the Settlement Payment stemming from the malpractice lawsuit is a return of capital to compensate for a loss or destruction of the capital of Insured.

The PLR looked to several cases and a revenue ruling involving amounts received by taxpayers in settlement of suits against tax return preparers, where the taxpayer alleged that the tax preparer’s mistakes caused the taxpayer to pay additional amounts of tax.

For example, in Clark, (1939) 40 B.T.A. 333, the tax counsel had prepared a joint return for the taxpayers, a husband and wife, and advised them to file it. It later turned out the joint return brought them a less favorable tax outcome than separate returns would have. The Clark court concluded that the payment that the taxpayers received from their tax counsel was compensation for the taxpayers’ loss which impaired their capital, or a return of the lost capital, and was not income since it was not “derived from capital, from labor or from both combined”.

No economic gain benefited Insured personally; rather, the Settlement Payment restored some of Insured’s impaired capital. Consistent with the holding of Clark, the recovery of impaired capital is excluded from Insured’s gross income as a restoration of lost capital.

And, as successor to Insured’s claim against Law Firm and in its capacity as Insured’s bankruptcy estate, the Settlement Payment in the hands of Taxpayer is also deemed as a return of capital to compensate for a loss or destruction of capital. Accordingly, the Settlement Payment is excludable from gross income of Taxpayer as successor.



This entry was posted in Newsletter, Tax Blog by William Murphy. Bookmark the permalink.

About William Murphy

William F. Murphy is the owner of Murphy Financial Group, P.C. The firm emphasizes in providing tax consulting and financial planning services to corporations, professional practices and individuals. He also provides consultation services on tax and financial planning issues to various news and publishing organizations on current tax law changes occurring within federal and state government. He is also the author of the “Murphy Minute” that is syndicated through various news organizations. Mr. Murphy is also associated with the law firm of Mallor Grodner LLP. The firm has offices in both Indianapolis and Bloomington Indiana. He assists in providing tax, valuation and financial analysis services focusing in the areas of Family law and business tax planning.