Litigation Support: Taxing Breach of Contract Settlement Proceeds

Taxes Can Have Impact on Negotiations of Settlements

Author: David Barrett

Attorneys need to understand how settlement proceeds are taxed, because taxability can have a significant impact on settlement negotiations. The IRS recently issued a legal memorandum that provides some guidance on the taxability of settlement proceeds resulting from a breach of contract.

The taxpayer in IRS Internal Legal Memorandum (ILM) 201203013 entered into a contract with a manufacturer to purchase a product. Pursuant to the contract, the taxpayer made nonrefundable deposits toward the final purchase price. When the manufacturer was unable to meet the delivery schedule, the taxpayer canceled the agreement. It subsequently contracted with another manufacturer to obtain the product at a higher price.

The taxpayer and the original manufacturer entered into a settlement agreement that paid the taxpayer financial compensation. This compensation was less than the amount the taxpayer paid the second manufacturer. The agreement also required the manufacturer to repay the deposits, plus interest.

Taxability factors

The taxpayer maintained that its capital was impaired to the extent of the excess of the purchase price from the second manufacturer over the original purchase price from the first manufacturer. Thus, it argued, all of the settlement payments were nontaxable because they contributed to restoring the taxpayer to its pre-breach position.

According to the IRS’s memo, the taxability of proceeds from a lawsuit or settlement depends on the nature of the claim and the actual basis of the recovery. If the amount recovered is tied directly to, and replaces, destroyed or injured capital, it’s a nontaxable return of capital — except when the amount recovered exceeds the tax basis of what was lost. In this case, the return of the deposits was return of capital — and therefore nontaxable. The interest, however, represented payment to the taxpayer for the use of the taxpayer’s money and was taxable.

As for the financial compensation, the IRS explained that settlement proceeds aren’t taxable if they do no more than restore the taxpayer to the position it was in before the loss. But if a contract breach causes a loss and the payment does more than restore the taxpayer to its pre-breach position, all or part of the recovery is taxable. Payments to compensate for lost income caused by the breach are also taxable.

Ultimately, ILM 201203013 took no position on whether the financial compensation described was taxable. It left the question to the Large Business and International Division of the IRS.

Open question

The settlement agreement described didn’t stipulate the grounds or purpose for the financial compensation. But the memo stressed that this fact alone shouldn’t dictate whether the compensation is taxable consideration for lost profits.

For any questions on the settlement agreement or any litigation support issue, contact us here or give us a call at 716.847.2651.