February 2011 Archives

February 15, 2011

Are Punitive Damages Excludable From Income?

You've got to hand it to the Greenbergs. It was a nice try, attempting to read between the lines of the Internal Revenue Code in an effort to justify excluding a punitive damages award from their income tax return.

Unfortunately, they couldn't convince the Tax Court. In a recent decision, the Court not only slapped the Greenbergs down in affirming a tax deficiency of over $1 million, but further hammered the folks in sanctioning the IRS imposed accuracy-related penalty, because the taxpayers had neither substantial authority, nor reasonable cause underlying their posture on the damage award. (The decision is Gary L. Greenberg, et ux. v. Commissioner, TC Memo 2011-18.)

Seems Mr. Greenberg, owner of a disability income policy, became disabled, thus precipitating a claim. The insurer paid some benefits, but not as much as Greenberg thought was proper, so he sued, alleging breach of contract and insurance bad faith. And, by golly, he won a damage award which included $2.4 million of punitive damages, which the taxpayers excluded from their return, justifying the exclusion on the basis of Internal Revenue Code Section 104(a)(3). (Learn more from Nolo: I won a lawsuit; do I have to pay tax on my damage award?)

Unfortunately that section only permits exclusion of "amounts received through accident or health insurance.....for personal injuries or sickness...." which "amounts" Mr. Greenberg liberally interpreted to include the punitive damages.

But the Court wasn't buying it, noting that, "In general, exclusions from income are narrowly construed," and with specific reference to IRC Section 104, that the Supreme Court had clearly spoken in the O'Gilvie case, to the effect that punitive damages received in a suit for personal injuries are not received "on account of" the personal injuries, themselves, but rather in connection with assessing a form of punishment on the offending party. Bottom line: punitive damages are taxable.

Attempting a novel twist on words, the Greenbergs also claimed that the punitive damages they received were not punitive, but "bad faith damages" (whatever that means), and that "damage awards that serve both to compensate and punish are excludable."

Perhaps the Greenbergs would have gotten farther had they found some citation in the published authority for this position, which they apparently did not.

One last point, of course, should be notation of the fact that the current application of IRC 104 only pertains to exclusion of compensatory damages "on account of personal physical injuries or physical sickness."

Pain and suffering just won't cut it.

February 14, 2011

IRS Tax Deadline is April 18 This Year

Good news for procrastinators everywhere: The IRS has announced that you'll have until April 18, 2011 to file your federal income tax returns for tax year 2010 (instead of the typical April 15 deadline).

That's because Emancipation Day -- a holiday observed in Washington, D.C. -- falls on April 15 this year, which is a Friday. And since any D.C. holiday affects tax deadlines the same way that a federal holiday would, this year's deadline for filing your federal returns is moved to Monday, April 18th.

This year's brief grace period also means that if you request an extension to file your 2011 return, you'll have until October 17, 2011 to file. But don't forget, an extension to file isn't the same as an extension to pay.

February 8, 2011

Noose Tightens on 'S' Corp Salary-vs-Dividend Issue

So here comes another "S" corporation shareholder who tried to play the "dividend" versus "salary" game and lost.

Say hello to Mr. Watson, a certified public accountant who apparently thought the value of his "services" to his wholly-owned "S" corporation was a mere $24,000 per year in the form of salary during 2002 and 2003, while at the same time receiving dividend distributions totaling over $175,000 annually. The case is Watson, P.C. vs. U.S. (DC IA 12/23/10) 107 AFTR 2d.

Unfortunately, Watson testified at trial that the reason his compensation was set at $24,000 for the years 2002 and 2003 was because he felt this was all the business could afford on a regular and continuous basis, given seasonality factors. He also testified that when setting his salary, he did not look at what comparable businesses paid for similar services, and was surprised to discover that he was paying himself less salary than that typically made by recent college graduates in the accounting field.

This has been an issue which IRS has pressed on for years -- indeed in 2010, they almost made it over the legislative hump (in forcing the issue) with House passage of legislation which would have lowered the boom on service professionals who try to minimize Medicare and Social Security taxes by funneling what is arguably self-employment income through an "S" corporation which pays the dough out in the form of a nominal salary with the rest in dividends. Thanks to non action by the Senate, the matter still languishes amidst a bunch of case law for guidance.

For their part, IRS actually issued some specific guidance in Fact Sheet 2008-25 (August, 2008) which laid out the major factors which the courts have considered in determining "reasonable compensation":

  • Training and experience
  • Duties and responsibilities
  • Time and effort devoted to the business
  • Dividend history
  • Payments to non-shareholder employees
  • Timing and manner of paying bonuses to key people
  • What comparable businesses pay for similar services
  • Compensation agreements
  • The use of a formula to determine compensation.

Surely we haven't heard the last on this issue.