Most of tax law is in “grey” areas. For instance, reasonable people, including those within the IRS bureaucracy, will disagree on what constitutes an “ordinary and necessary” business expense—a big area of tax deductions.
Another area concerns whether litigation proceeds to compensate for damages to farm or ranch property constitute taxable income.
There are many lawsuits brought by owners of ranches, horse farms and agricultural farms against chemical companies and others for environmental torts.
These cases often pertain to damages caused to land, leasehold, crops, livestock, other inventory, or other interests that result in diminished profits and loss of goodwill. Sometimes the claim also includes personal injuries to the health and well-being of the owner and family, including health problems such as chronic respiratory illnesses.
Sometimes cases have been brought against companies for product liability, such as for fungicides that may have been unsafe and resulted in damages to property. Other cases in which large settlements have been received have involved environmental damage that severely impacted on the ability to conduct business.
When a judgment or settlement is made in connection with civil litigation, the amount may be significant so as to compensate the plaintiff for business interruption and other damages.
The question arises, how are such proceeds to be treated for income tax purposes? Often, accountants will advise farmers and ranchers that such proceeds must be reported as ordinary income because they are treated as proceeds for loss of profits.
As a general rule, if damages are awarded as restitution for compensation or lost profits, such payments are ordinary income.
Sometimes plaintiffs also receive proceeds from use and occupancy insurance, which is intended to compensate for business interruption, and this further complicates the picture. In tax opinion letters I have generated, I have found that in many instances, people have overpaid on taxes with respect to settlement proceeds and in some instances, they are entitled to completely exclude the proceeds from income tax. Proceeds from damages to farmers and ranchers can, in many situations, be allocated as a return of capital with respect to intangible assets such as goodwill, franchises, trademarks, or other assets that represent valuable legal rights in a business. Also, damages for loss of inventory by reason of the acts of the defendants can be characterized as capital rather than profits. This can result in substantial tax savings. Generally speaking, if damages are properly allocated as compensation for injury to goodwill or other intangible assets, such recoveries may be tax-free.
For example, in a recent case, I provided legal guidance to farmers who won a settlement against a chemical company for environmental damages to their farms.
The amount of the proceeds to each farmer was very significant.
I was able to separately identify goodwill and other intangibles as the basis for the recovery, and through documentation and a tax opinion letter, allocated the money so that the taxpayers could exclude the proceeds from gross income.
Goodwill is unique because unlike receivables, inventories, and patents that can be sold or exchanged individually in the marketplace, goodwill can be identified only with the business as a whole. For example, a substantial list of regular customers and an established reputation are unrecorded assets that give the enterprise a valuation greater than the sum of the fair market value of the individual identifiable assets.
Numerous factors go into determining the value of goodwill that an enterprise has generated. If damages include personal injuries, it is possible to exclude the proceeds from income tax, depending on the nature of the injuries and how the settlement agreement is worded. IRS Code section 104(a)(2) states that the compensation can be excluded from income if on account of “personal physical injuries or physical illness.”
The meaning of “physical” is ambiguous, and there is a split of opinion as to whether compensation for symptoms of mental distress, or symptoms that seem to defy medical diagnosis, can be excluded from income.
This is a grey area of tax law, and different courts have come to different conclusions as to whether proceeds to compensate for, say emotional distress, constitute taxable income. Because a considerable amount of money can be at stake, it is important to seek legal tax advice in such situations.
In order for settlement proceeds or a judgment from a civil lawsuit to be excluded from tax, it is important to structure the settlement agreement to clearly indicate how the funds are being allocated—whether they are to compensate for loss of good will, property damage, and/ or personal injuries, and if so, the nature of the injuries.
But, clearly, if a settlement is to compensate the plaintiff for property damage and for loss of goodwill, the proceeds generally are excluded from income tax. Goodwill is an extremely important element in any viable business.
Goodwill consists of: a superior management team, outstanding sales organization, effective advertising, good labor relations, outstanding credit rating, high standing in the community, favorable government regulation, favorable association with others in the industry, strategic location, good public relations, stability and assurance of supply, and recognizable brand name or trade name. In general, goodwill represents the total earning power of a business. — John Alan Cohan, Attorney at Law
[John Alan Cohan is a lawyer who has served the farming, horse and livestock industries since 1981. He serves clients in all 50 states, and can be reached by telephone at 310/278-0203 or via e-mail at JohnAlanCohan@ aol.com. His Web site is at www.JohnAlanCohan.com.]