Category: Individuals
Subject: Lawsuit Settlement
Title: Tax Treatment of Broker Mismanagement Settlement
IRC Sections: 61
Filename: 1313.html
Date Produced: 03/94

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Taxpayer (TP) suffered a loss of approximately $1 million in his investment portfolio allegedly as a result of broker mismanagement of his affairs. The loss was treated for tax purposes as a capital loss subject to the $3,000-per-year limitation. Thus, TP has an extremely large capital loss carryforward. In a subsequent tax year, TP received a settlement payment of approximately $230,000 in connection with his lawsuit against the broker.

Issue
What is the appropriate tax treatment of the settlement?

Answer
There is considerable support to indicate that the settlement should be treated as capital gain which would of course be offsettable by the capital loss carryforward.

Discussion
There are really two issues at work here. First, is there any income at all with respect to the settlement; and second, if there is income, what is its character?

As to the first issue, TP has clearly gained in an economic sense from the settlement payment. Under the all-inclusive concept of §61 which provides that gross income means income from whatever source derived, it would appear on its face that the settlement payment should be taken into account as income for tax purposes. You suggested in our conversations that the settlement might be excluded from income as a return of capital under the principles set forth in Revenue Ruling 81-277. I disagree with that approach. TP's capital with respect to his stock has already been recovered through the computation of gain or loss for each security sold. The problem is that TP has been prevented from enjoying a tax benefit with respect to that basis through operation of the capital loss limitation rules. Without some specific provision of law or some judicially-created principle to exclude TP's economic gain, it is my view the settlement is taxable to TP under the general principles of §61.

As to the character issue, consider the following.

1. One of the fundamental and overriding principles with respect to determining the tax treatment of the proceeds of a settlement or judgment is the so-called "origin of the claim" doctrine. The concept underlying the origin of the claim doctrine is that any recovery should be taxed in the same manner as the item for which it is intended to substitute. Any settlement or judgment payments should be treated for tax purposes as if the economic damage which is the subject of the suit had not occurred. See U.S. v. Gilmore, 372 U.S. 39 (1963), rev'g and rem'g 290 F.2d 942 (Ct. Cl. 1961); U.S. v. Patrick, 372 U.S. 53 (1963), rev'g and rem'g 288 F.2d 292 (4th Cir. 1961); and Hort v. Comr., 313 U.S. 28 (1941), aff'g 112 F.2d 167 (4th Cir. 1940), aff'g 39 B.T.A. 922 (1939), acq., 1939-2 C.B. 18.

In this instance, the origin of the claim is improper handling of capital assets, namely the portfolio, resulting in a diminution of value of those assets. Since the claim relates to a capital asset, it follows under the origin of the claim doctrine that the recovery should also be capital in nature.

2. In the case of F.D. Arrowsmith, 52-2 USTC ¶9527, the Supreme Court considered the case of the shareholders of a liquidated corporation who were forced some years after the liquidation to pay damages related to the operation of the former corporation. The taxpayer in Arrowsmith deducted the damage payments as ordinary business expenses. The Supreme Court held that the subsequent payments were part of the original liquidation transaction and in effect a diminution of the proceeds from that original transaction. Accordingly, capital loss treatment was required with respect to the subsequent payments. It appears to me that the principle of Arrowsmith is directly applicable to TP's facts. The Arrowsmith case has been broadly embraced by the courts and the IRS and has been applied to taxpayers in wide variety of circumstances. Arrowsmith's precepts seem to be appropriate in this case as well. It is also important to note that the IRS has applied Arrowsmith to a gain situation as well. In Revenue Ruling 79-278, 1979-2 C.B. 302, the IRS ruled that a corporation that incurred a short-term capital loss with respect to a sale of stock and received a settlement in a subsequent tax year (the taxpayer alleged that violation of the securities laws had occurred) was entitled to short-term capital gain treatment for the subsequent payment under the Arrowsmith doctrine.

Based on the foregoing explanation, it is my view that very strong support exists for treating the settlement payment as capital gain in the year of receipt.