Tax Penalty Imposed on Former Plaintiff

 Greenberg v. Commissioner (T.C. 2011-18), a January 24, 2011 Tax Court decision, highlights the risks and potential penalties for improperly reporting the tax consequences of a settlement and provides a warning for advisers, including structured settlement and settlement planning consultants, who offer tax advice to recipients of settlement payments.

The Tax Court agreed with the IRS that Gary Greenberg failed to report the required portion of a $3.3 million bad faith and breach of contract award and imposed a substantial penalty for the underpayment.

Mr. Greenberg became disabled in 1990 and began receiving payments from a private disability income insurance policy he had purchased in 1988. When the life insurance company stopped making payments after eight years, Mr. Greenberg sued for insurance bad faith and breach of contract. An Arizona federal court awarded him $940,000 for past and future disability payments and premiums plus costs fees and interests. In addition, the court awarded Mr. Greenberg $2.4 million in punitive damages for a total of $3.3 million.

Mr. Greenberg failed to report any portion of the award on his tax return and did not otherwise disclose the award to the IRS. In Tax Court, Mr. Greenberg conceded the interest portion of his award was taxable but he argued that the $2.4 million of punitive damages should be received tax free "for personal injuries or sickness" under IRC section 104(a)(3).

The Tax Court disagreed and held that the punitive damages were not received "for personal injuries or sickness" and therefore constituted taxable income as did the portion of the costs and fees attributable to the punitive damages.

Gross income under IRC sections 104(a)(1)-(5) does not include amounts received for:

• (1) - Workers compensation ("as compensation for personal injuries or sickness")
• (2) - Traditional injuries ("on account of personal physical injuries or sickness")
• (3) - Accident & health insurance ("for personal injuries or sickness")
• (4) - Government pensions & annuities ("as a pension, annuity, or similar allowance for personal injuries or sickness")
• (5) - Terrorism injuries ("by an individual as disability income attributable to injuries incurred as a direct result of a terroristic or military action")

In Commissioner v. Schleier (1995), the U.S. Supreme Court implied that the language in each of the section 104(a) exclusion provisions should be read the same even if not written the same.  In 1996, Congress specifically included punitive damages in a taxpayer's gross income under section 104(a)(2).

As a result, the Tax Court in Greenberg determined a large understatement of tax and imposed an accuracy-related penalty under IRC 6662. The penalty under IRC 6662 amounts to 20% of the underpayment attributable to a taxpayer's "negligence" or "disregard of rules or regulations" or "substantial understatement" of income tax. Significantly, Mr. Greenberg did not produce any evidence that he relied on professional advice nor did he make any relevant disclosures on his tax return.

For purposes of IRC section 6662:

• "Negligence" includes any failure to make a reasonable attempt to comply with the provisions of the Tax Code.
• "Disregard of rules or regulations" includes any careless, reckless, or intentional disregard.
• A taxpayer is "careless" if he or she does not exercise reasonable diligence to determine the correctness of a tax return position contrary to the rules or regulations.
• The penalty will not be imposed on any portion as to which the taxpayer acted with reasonable cause and in good faith.
• A substantial underpayment of tax exists if an underestimate exceeds the greater of 10% of the tax required to be shown on the tax return or $5000.
• The amount of understatement is reduced if there is or was substantial authority for the taxpayer's treatment of any portion, or if the taxpayer disclosed the relevant facts affecting the tax treatment and there is a reasonable basis for the taxpayer's treatment.

Based upon these rules, Mr. Greenberg probably would not have been able to avoid tax penalties simply by visiting with a tax adviser or making disclosures on his tax return. On the other hand, had Mr. Greenberg met with a competent adviser, he probably would have reported the income on his tax return and avoided the penalty.

The Greenberg case can be compared and contrasted with the Texas case of Grillo v. Pettiete. In the Grillo case, the defendants offered periodic payments (structured settlement) to settle a medical malpractice case. Although the case settled for $2.5 million, the plaintiff attorneys rejected the structured settlement. When the settlement funds subsequently were exhausted, the Grillo family sued the plaintiff attorney and guardian ad litem for negligence and legal malpractice. The parties settled for more than $4 million.

Both the Greenberg and Grillo cases highlight why settlement recipients need good professional advice. The Grillo case more specifically points out the potential risks for settlement advisers who give bad or incomplete advice.

Thanks to Jeremy Babener for alerting S2KM about the Greenberg case. Currently a NYU Tax LL.M. Candidate, and a former Fellow at the U.S. Treasury's Office of Tax Policy, Babener's writing appears on his website Tax Structuring and is featured on S2KM's structured settlement public policy wiki.