A malpractice settlement that just restores lost capital is not taxable income

Plain-English summary

A driver caused a fatal accident and lost a large wrongful-death judgment after the insurer's defense law firm failed to settle the case within the auto policy limits. The driver went bankrupt, and the bankruptcy estate's main asset was a legal-malpractice claim against that law firm and the insurer for exposing the driver to the excess judgment. The estate settled the malpractice suit for a substantial payment (excluding any punitive damages) and asked the IRS whether that money is taxable. The IRS ruled it is not: applying the classic "in lieu of what were the damages awarded?" test from Raytheon, and following Clark and Concord Instruments (plus Rev. Ruls. 57-47 and 81-277), the payment compensates for the destruction of the driver's capital caused by the firm's negligence, so it is a nontaxable return of capital rather than an economic gain. Because the estate stands in the driver's shoes as successor to the claim, the settlement is likewise excluded from the estate's gross income under § 61. The broader point: damages that merely make a taxpayer whole for lost or impaired capital, as opposed to replacing lost profits, are generally excluded from income.

Ruling snapshot

• Question: Is a legal-malpractice settlement received by a bankruptcy estate (as successor to the debtor's claim) includible in gross income, or is it an excludible return of capital?
• Outcome: Approved (favorable ruling: the settlement is excludible from gross income as a return of capital).
• Key authorities: IRC § 61; Raytheon Prod. Corp. v. Commissioner; Clark v. Commissioner; Concord Instruments v. Commissioner; Rev. Rul. 57-47; Rev. Rul. 81-277.

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201831011                                              Third Party Communication: None
Release Date: 8/3/2018                                         Date of Communication: Not Applicable
Index Number: 61.00-00
                                                               Person To Contact:
------------------------------------------------               -------------------------, ID No. -----------------
------------------------------------------------------------   -----------------------------------------------------

-                                                              Telephone Number:
------------------------                                       ----------------------
-------------------------------------------                    Refer Reply To:
                                                               CC:ITA:B05
                                                               PLR-136025-17
                                                               Date:
                                                               May 08, 2018


Legend

Tax Year          =        -------

Taxpayer          =        -------------------------------------------------------------

Insured           =        --------------------------------

Date 1            =        --------------------------

Date 2            =        ---------------------------

Date 3            =        --------------------


Dear ------------------------------------------------:

This letter responds to your ruling request submitted on behalf of Taxpayer by letter
dated November 29, 2017. You request a ruling on the tax treatment of funds
recovered in settlement of a lawsuit. You request a ruling that the funds recovered in
the settlement be excluded from gross income, on the basis that funds are properly
deemed a return of capital to compensate for a loss or destruction of capital.

                                                        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, Insured’s automobile insurance company (“Insurer”), and
PLR-136025-17                                 2

Insured’s employer. Insured was represented by the automobile insurance company’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 settled with Insured’s employer but went to trial against Insured and
Insurer. After trial, a significant judgment was granted against Insured. Stunned by the
judgment against Insured, Insured filed for bankruptcy protection on Date 1. On Date 2,
the victim’s family filed a proof of claim with the bankruptcy court in the amount of the
judgment, plus interest.

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”).

On Date 3, 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”). While Taxpayer made a claim for punitive damages in
instituting the malpractice lawsuit, the Settlement Payment specifically does not include
punitive damages. The settlement was approved by the bankruptcy court. While
substantial, the Settlement Payment from Law Firm to Taxpayer is still insufficient to
satisfy Insured’s liability to the victim’s family. As a fiduciary for the creditors of the
bankruptcy estate, comprised almost exclusively of the victim’s family, Taxpayer
expects to distribute the proceeds of the Settlement Payment to the victim’s family.
Taxpayer wants to exclude the Settlement Payment from its income.

                                  LAW AND ANALYSIS

Unless provided otherwise in subtitle A of the Internal Revenue Code, gross income
includes “all income from whatever source derived.” I.R.C. § 61(a). For a taxpayer to
have income under § 61, there must be an economic gain that benefits the taxpayer
personally. Rev. Rul. 81-277, 1981-2 C.B. 14, citing United States v. Gotcher, 401 F.2d
118, 121 (5th Cir. 1968). Thus, the concept of economic gain is inherent in § 61.

“When a claim is resolved by settlement, the relevant question for the tax treatment of a
settlement award is: ‘In lieu of what were the damages awarded?’” Milenbach v.
Commissioner, 318 F.3d 924, 932 (9th Cir. 2003) (quoting Raytheon Prod. Corp. v.
Commissioner, 144 F.2d 110, 113 (1st Cir. 1944)). See also Getty v. Commissioner,
913 F.2d 1486, 1490 (9th Cir. 1990). The payments are includible in gross income if
they are to replace lost profits. Milenbach, 318 F.3d at 933; Raytheon, 144 F.2d at 113.
The payments are excludible from gross income as a return of capital if they are to
compensate for the loss or destruction of capital. Milenbach, 318 F.3d at 933;
Raytheon, 144 F.2d at 113.
PLR-136025-17                                 3


Taxpayers may exclude an amount they received from their tax counsel if the amount
received is to compensate for additional income tax the taxpayers had to pay as a result
of the tax counsel's error in return preparation. Clark v. Commissioner, 40 B.T.A. 333
(1939), acq. 1957-1 C.B. 4. In Clark, 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 Board concluded that the payment 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.’” Clark at 335 (citing
Merchants’ Loan & Trust Co. v. Smietanka, 255 U.S. 509, 518 (1921), which in turn
quotes from Eisner v. Macomber, 252 U.S. 189, 207 (1920)).

In Rev. Rul. 57-47, 1957-1 C.B. 23, issued concurrently with the acquiescence in Clark,
the Commissioner analyzed nearly the same facts as in Clark. The Commissioner held
(1) that no taxable income is derived from that portion of the settlement proceeds that
does not exceed the amount of tax that the taxpayer was required to pay because of the
return preparer’s error; and (2) that the remainder of the proceeds that represented
interest on the overpaid tax and the fees that the taxpayer paid to the preparer and
deducted must be included in gross income.

Rev. Rul. 81-277 held that a payment received from a contractor, for failure to fulfill a
contractual obligation and in an amount equal to the contractor’s estimated cost to
satisfy the obligation, was excludible as a return of capital.

A taxpayer who received $125,000 in settlement of a malpractice claim against an
attorney who failed to file a notice of appeal from a Tax Court decision against the
taxpayer was permitted to exclude a portion of the settlement as a return of lost capital.
Concord Instruments v. Commissioner, T.C. Memo. 1994-248. The taxpayer in
Concord Instruments had originally sought $466,034 for the attorney’s failure to timely
file the notice of appeal, which consisted of $160,000 in deficiency paid, $265,012 in
interest on the deficiency, and $41,002 in interest paid to a third party that lent the
money to pay the deficiency. Relying heavily on Clark and citing favorably Rev. Rul. 57-
47 and Rev. Rul. 81-277, the Tax Court held that the portion of the $125,000 settlement
attributable to the deficiency was excluded from the taxpayer’s gross income as a
restoration of capital. The court specifically rejected the Commissioner’s argument that
the tax paid by the taxpayer resulted from the adverse Tax Court decision and not from
the attorney's failure to file a notice of appeal. Instead, the court looked to the
taxpayer’s claim against the attorney to characterize the nature of the payment received
in the settlement, and it did not evaluate the validity of the claim or whether the taxpayer
would have prevailed had a timely notice of appeal been filed.

The professional negligence of the Law Firm representing Insured resulted in a
significant judgment against Insured, which is a loss or destruction of the capital of
PLR-136025-17                                         4

Insured. As such, the subsequent Settlement Payment stemming from the malpractice
lawsuit is a return of capital to compensate for a loss or destruction of the capital of
Insured. No economic gain benefits Insured personally; rather, the Settlement Payment
restores some of Insured’s impaired capital. Consistent with the holdings of Clark and
Concord Instruments, the recovery of impaired capital is excluded from Insured’s gross
income as a restoration of lost capital. Additionally, as successor to Insured’s claim
against Law Firm and in its capacity as Insured’s bankruptcy estate,1 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 excludible
from gross income of Taxpayer as successor.

                                            CONCLUSION

Funds recovered in the settlement – the Settlement Payment – is excludible from gross
income of Taxpayer, on the basis that funds are properly deemed a return of capital to
compensate for a loss or destruction of capital.


This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

                                             Sincerely,



                                             William A. Jackson
                                             Branch Chief, Branch 5
                                             (Income Tax & Accounting)



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1
 Property of the bankruptcy estate is identified in 11 U.S.C. § 541 and generally includes all legal and
equitable interests of the debtor in property as of the commencement of the bankruptcy.