McKay v. Commissioner, 102 T. C. 465 (1994)

The tax treatment of settlement proceeds hinges on the express allocations made in a settlement agreement reached through bona fide, arm’s-length negotiations.

Summary

Bill E. McKay, Jr. , a former Ashland Oil executive, received a $16. 7 million settlement from Ashland after being wrongfully discharged. The settlement agreement allocated $12. 25 million to a tort claim for wrongful discharge and $2 million to a contract claim. The Tax Court upheld the settlement’s allocations as valid, excluding the tort portion from income under IRC §104(a)(2). McKay’s legal fees were deductible only to the extent of the taxable portion of the settlement. The case illustrates the importance of settlement agreements in determining the taxability of damages and the application of IRC §265 to legal expenses.

Facts

McKay was terminated by Ashland Oil after refusing to participate in illegal activities. He sued Ashland for wrongful discharge, breach of contract, RICO violations, and punitive damages. The jury awarded McKay over $43 million, but the parties settled for $25 million, with McKay receiving $16. 7 million. The settlement agreement allocated $12. 25 million to McKay’s wrongful discharge tort claim and $2 million to his breach of contract claim. No settlement proceeds were allocated to RICO or punitive damages. McKay deducted legal expenses on his tax returns, which the IRS challenged.

Procedural History

McKay filed a wrongful discharge lawsuit in federal district court against Ashland Oil. After a jury awarded damages, the parties settled. McKay then filed tax returns claiming deductions for legal fees and excluding part of the settlement from income. The IRS issued notices of deficiency, and McKay petitioned the Tax Court. The Tax Court upheld the settlement allocations but limited the deductibility of legal expenses.

Issue(s)

1. Whether the portion of settlement proceeds allocated to McKay’s wrongful discharge tort claim is excludable from gross income under IRC §104(a)(2).
2. Whether, and to what extent, McKay’s legal and litigation-related expenses are deductible under IRC §162.
3. Whether McKay is liable for additions to tax for failure to timely file his 1984, 1985, and 1986 tax returns under IRC §6651(a)(1).

Holding

1. Yes, because the settlement agreement was the result of bona fide, arm’s-length negotiations and accurately reflected the substance of the claims settled.
2. Yes, but only to the extent of 26. 8% of the legal expenses allocated to the wrongful discharge action, as this percentage corresponds to the taxable portion of the settlement proceeds under IRC §265.
3. Yes, because McKay’s deliberate delay in filing to prevent Ashland from obtaining tax return information during discovery did not constitute reasonable cause.

Court’s Reasoning

The Tax Court emphasized the importance of the settlement agreement’s express allocations in determining the tax treatment of damages. The court found that the settlement was the result of adversarial negotiations, with Ashland refusing to allocate any proceeds to RICO claims. The court distinguished this case from Robinson v. Commissioner, where the settlement allocation was disregarded due to lack of adversity. The court applied IRC §104(a)(2) to exclude the wrongful discharge tort proceeds from income, as they were damages received on account of a tort-type personal injury. For legal expenses, the court applied IRC §265, limiting deductibility to the taxable portion of the settlement. The court rejected McKay’s argument that delaying tax return filings was reasonable cause under IRC §6651(a)(1), citing the lack of legal basis for such a delay.

Practical Implications

This decision underscores the importance of carefully drafting settlement agreements to allocate damages between taxable and non-taxable categories. Taxpayers and their attorneys should ensure that settlement negotiations are adversarial and documented to support the allocations made. The case also illustrates the application of IRC §265 in limiting the deductibility of legal fees to the taxable portion of a settlement. Practitioners should be aware that delaying tax return filings to prevent discovery in litigation is not considered reasonable cause under IRC §6651(a)(1). Subsequent cases like Commissioner v. Banks have further clarified the tax treatment of legal fees in settlement agreements, reinforcing the principles established in McKay.