Tax Treatment of Class Action Settlement


J

Jeff Wisnia

About five years ago my favorite stockbroker made one of his
infrequent poor calls and I lost a bundle on a
pharmaceutical company stock that tanked overnight when news
of serious fiscal irregularities broke.

I owned some shares in my regular (taxable)brokerage account
and some in an IRA.

I declared a capital loss for shares sold in my regular
account, for the tax year in which they were sold.

I'd received a notice last year of a class action suit
against the company and some of its officers and replied
with proof of purchases of the stock made during specified
time periods.

Today's mail brought me two settlement checks representing
the proceeds of that suit.

Are the following the correct ways to treat the funds I just
received?

1. for the settlement related to the IRA account, just put
the funds received back into the IRA?

2. For the settlement related to the regular account,
declare the funds received as a capital gain on my 2006 tax
return?

Thanks guys,

Jeff

--
Jeffry Wisnia

(W1BSV + Brass Rat '57 EE)

"Truth exists; only falsehood has to be invented."
 
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I

Ira Smilovitz

Jeff Wisnia said:
About five years ago my favorite stockbroker made one of his
infrequent poor calls and I lost a bundle on a
pharmaceutical company stock that tanked overnight when news
of serious fiscal irregularities broke.

I owned some shares in my regular (taxable)brokerage account
and some in an IRA.

I declared a capital loss for shares sold in my regular
account, for the tax year in which they were sold.

I'd received a notice last year of a class action suit
against the company and some of its officers and replied
with proof of purchases of the stock made during specified
time periods.

Today's mail brought me two settlement checks representing
the proceeds of that suit.

Are the following the correct ways to treat the funds I just
received?

1. for the settlement related to the IRA account, just put
the funds received back into the IRA?

2. For the settlement related to the regular account,
declare the funds received as a capital gain on my 2006 tax
return?
Yes, and yes.

Ira Smilovitz
 
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L

LTSLLC

What you do with the settlement funds and how you pay taxes,
if any, are two different things.

You can cash the check and spend it any way you want,
including putting the money into your IRA.

The settlement proceeds, for tax purposes, are unrelated to
the IRA. However, they are taxable income to you and should
be reported on line 21 of Form 1040 as "other income". You
should be getting a Form 1099 from the company sometime next
January.

Rudy
www.LizcanoTaxServicesLLC.com
 
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I

Ira Smilovitz

LTSLLC said:
What you do with the settlement funds and how you pay taxes,
if any, are two different things.

You can cash the check and spend it any way you want,
including putting the money into your IRA.

The settlement proceeds, for tax purposes, are unrelated to
the IRA. However, they are taxable income to you and should
be reported on line 21 of Form 1040 as "other income". You
should be getting a Form 1099 from the company sometime next
January.
This advice is entirely wrong. The settlement of a class
action suit involving changes in stock price is almost always
a return of capital. If the shares which qualified the
shareholder as part of the class are no longer owned, the
return of capital is reported as a capital gain with zero cost
basis.

In the case presented by the original poster, some of the
shares were owned in an IRA and some in a taxable account.
Failure to deposit the IRA settlement amount back into the IRA
(or another IRA) will be considered as a distribution from the
IRA, subject to the same tax and penalty that any other
distribution would be.

Ira Smilovitz
 
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D

dcaro1

I would think you have a direct Arrowsmith application here.
 
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L

LTSLLC

Jeff,

My advise is entirely correct.

As a taxpayer, you of course would want to claim it as
capital gains but the IRS would want it characterized as
ordinary income.

The settlement amount paid to you DOES NOT come from the
actual sale or exchange of the stocks, it is paid to you for
damages you suffered and generally, damages are ordinary
income.

1=2E The Internal Revenue Code's definition of a capital
gain or loss is set forth in =A71222 as the gain or loss
"from the sale or exchange of a capital asset." The court
settlement you received MUST comply with that requirement
to qualify for capital gain treatment. It doesn't as stated
above, it was for damages and NOT for the sale or exchange
of a capital asset.

2=2E In some cases, courts have used the origin-of-the claim
test to determine if the income is ordinary income or
capital gain income. However, in a recent case on appeal,
Nahey (99-2 USTC 50, 967 (CA-7, 1999), aff'g 111 TC 256),
the court bypassed that test and decided that damages were
ordinary rather than capital because settling a lawsuit does
not constitute a sale or exchange. In other words, they
applied the plain meaning of Code section 1222.

As to the Arrowsmith (Arrowsmith v. Comr., 344 U.S. 6
(1952)) case applying, I don't think it does as the IRS
would not view the lawsuit several years later as a
sufficiently related transaction or so integrally related to
the original stock sales.

Arrowsmith stands for the proposition that "when a later
transaction is sufficiently related to an earlier
transaction, the later transaction will be treated as having
the same character as the earlier transaction."

I always err on the side of caution and always have
references to IRC citations, court cases, etc. to back up my
advice to clients or when I prepare their tax returns or
claims.

However, you may be more willing to accept the risk of an
IRS audit, so by all means, claim it as capital gains and
then spin the IRS audit wheel. I can tell you now that you
would lose in an audit.

Rudy
www.LizcanoTaxServicesLLC.com
 
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P

pgattocpa

LTSLLC said:
My advise is entirely correct.

As a taxpayer, you of course would want to claim it as
capital gains but the IRS would want it characterized as
ordinary income.

The settlement amount paid to you DOES NOT come from the
actual sale or exchange of the stocks, it is paid to you for
damages you suffered and generally, damages are ordinary
income.

1=2E The Internal Revenue Code's definition of a capital
gain or loss is set forth in =A71222 as the gain or loss
"from the sale or exchange of a capital asset." The court
settlement you received MUST comply with that requirement
to qualify for capital gain treatment. It doesn't as stated
above, it was for damages and NOT for the sale or exchange
of a capital asset.

2=2E In some cases, courts have used the origin-of-the claim
test to determine if the income is ordinary income or
capital gain income. However, in a recent case on appeal,
Nahey (99-2 USTC 50, 967 (CA-7, 1999), aff'g 111 TC 256),
the court bypassed that test and decided that damages were
ordinary rather than capital because settling a lawsuit does
not constitute a sale or exchange. In other words, they
applied the plain meaning of Code section 1222.

As to the Arrowsmith (Arrowsmith v. Comr., 344 U.S. 6
(1952)) case applying, I don't think it does as the IRS
would not view the lawsuit several years later as a
sufficiently related transaction or so integrally related to
the original stock sales.

Arrowsmith stands for the proposition that "when a later
transaction is sufficiently related to an earlier
transaction, the later transaction will be treated as having
the same character as the earlier transaction."

I always err on the side of caution and always have
references to IRC citations, court cases, etc. to back up my
advice to clients or when I prepare their tax returns or
claims.

However, you may be more willing to accept the risk of an
IRS audit, so by all means, claim it as capital gains and
then spin the IRS audit wheel. I can tell you now that you
would lose in an audit.
We do not know enough facts to know whether capital or
ordinary treatment is proper. The mere fact that the law
suit took five years is meaningless in and of itself. Time
to first hearting, appeals, etc. could all be factors that
would not affect the relationship between the earlier and
later transactions. The wheels of justice turn slowly.

Many security cases specifically state that the damages are
calculated on each investor's purchase and selling price.
In those cases, the proceeds would, in my opinion, most
certainly be afforded capital gain treatment.

In other cases, the damages are specifically described as
something that would not afford capital treatment.

So the charge to the OP is to read the language in the
original documentation informing him how to particiapte and
how his share of any damages would be calculated as well as
the language accompanying the checks. (Or to have his tax
advisor do so.)

As to the comment about always erring on the side of
caution, well it is your business and you have to do what
you think is best. However, the cautious side does not
always harbor the correct answer to a tax law question and,
therefore, not the best answer for the client because he /
she is paying a higher tax bill than necessary.

Peter C. Gatto, CPA
 
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J

Jeff Wisnia

LTSLLC said:
My advise is entirely correct.

As a taxpayer, you of course would want to claim it as
capital gains but the IRS would want it characterized as
ordinary income.

The settlement amount paid to you DOES NOT come from the
actual sale or exchange of the stocks, it is paid to you for
damages you suffered and generally, damages are ordinary
income.

1=2E The Internal Revenue Code's definition of a capital
gain or loss is set forth in =A71222 as the gain or loss
"from the sale or exchange of a capital asset." The court
settlement you received MUST comply with that requirement
to qualify for capital gain treatment. It doesn't as stated
above, it was for damages and NOT for the sale or exchange
of a capital asset.

2=2E In some cases, courts have used the origin-of-the claim
test to determine if the income is ordinary income or
capital gain income. However, in a recent case on appeal,
Nahey (99-2 USTC 50, 967 (CA-7, 1999), aff'g 111 TC 256),
the court bypassed that test and decided that damages were
ordinary rather than capital because settling a lawsuit does
not constitute a sale or exchange. In other words, they
applied the plain meaning of Code section 1222.

As to the Arrowsmith (Arrowsmith v. Comr., 344 U.S. 6
(1952)) case applying, I don't think it does as the IRS
would not view the lawsuit several years later as a
sufficiently related transaction or so integrally related to
the original stock sales.

Arrowsmith stands for the proposition that "when a later
transaction is sufficiently related to an earlier
transaction, the later transaction will be treated as having
the same character as the earlier transaction."

I always err on the side of caution and always have
references to IRC citations, court cases, etc. to back up my
advice to clients or when I prepare their tax returns or
claims.

However, you may be more willing to accept the risk of an
IRS audit, so by all means, claim it as capital gains and
then spin the IRS audit wheel. I can tell you now that you
would lose in an audit.
I'll go with your advice and if I get a 1099 related to the for
the shares held in in my regular brokerage account next year I'll
show it as regular income, the amount is only about $750.00 and
The difference in tax between ordinary income and a capital gain
wouldn't be large enough to warrant fighting the eagle over.

The other settlement check, for the shares in my IRA brokerage
account, was payable to the IRA so I mailed it to my broker who
put it the IRA account. I feel comfortable about doing it that
way, do you too?

Thanks,

Jeff
 
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