Frost Law
Trust litigation is often complex and emotionally challenging, especially for beneficiaries and trustees during the trust administration process. One often overlooked but critical aspect of trust litigation is the taxation of judgments and settlements, which can substantially impact the final amount beneficiaries receive. Being aware of the tax implications associated with different types of settlements is essential for beneficiaries to make informed decisions throughout the litigation process.
Under Section 61 of the Internal Revenue Code (IRC), gross income generally includes “income from whatever source derived” unless specifically exempted by a specific statute or case law. Most notably, it is important to distinguish between recoveries from physical injuries and those from non-physical injuries, such as trust litigation or business litigation recoveries. Regardless of whether the damages result from a judgment, arbitration judgment, or settlement, for tax purposes, the principles remain the same.1 Here is a brief overview of the tax treatment for different types of litigation recoveries.
One of the most instructive cases in the tax treatment of trust litigation settlement recoveries is Getty v Commissioner2 (913 F.2d 1486 9th circuit 1990). In this case, Ronald Getty was the beneficiary of an irrevocable trust established by his father, J. Paul Getty, and his grandmother, providing him with income for life, with the remainder to his children and descendants. The trust also benefitted his three half-brothers, who received three times more income than Ronald. Though Ronald’s father promised to remedy the unequal distributions between Ronald and his brothers, no changes were made to the trust before his father’s death.
Following his father's passing, Ronald brought suit — not to contest the will or directly claim from the estate — but to establish a constructive trust over assets transferred to the Getty Museum from his father’s estate, claiming this would equalize what he should have received if his father had fulfilled his promise. The case was settled, and Ronald received $10 million from the Museum. However, he did not report this amount as taxable income, asserting that it was excludable as an inheritance under IRC Section 102(a).
The IRS disagreed and assessed a deficiency, leading to Ronald's argument that the funds should be treated as a nontaxable inheritance. This case is a pivotal example of how settlements in trust litigation can hinge on the interpretation of inheritance exclusions under the tax code.
The Tax Court initially ruled in favor of the IRS, ruling that the settlement Ronald Getty received was taxable as income. However, the 9th Circuit Court of Appeals overturned this decision, ruling that the settlement qualified for income exclusion under IRC Section 12(a). The appellate court took a broader view of Ronald’s claim, interpreting it as a request from J. Paul Getty’s estate in an amount equivalent to what his siblings had received.
Additionally, the court stated that it was not necessary for Ronald to establish that his father would have fulfilled his promise through a direct bequest. The court reasoned that if J. Paul Getty had “kept his promise, he would have done so by a bequest of property, probably of Getty Oil stock.” As a result, the court found that the settlement could be excluded from Ronald's taxable income.
The “Origin of the Claim” test, developed through case law, is used to determine the tax treatment of amounts received from a judgment or settlement to the recipient of such recovery.3 By examining the origin and nature of the underlying claim, the test helps establish:
This test ensures that the tax treatment aligns with the fundamental nature of the claim rather than the structure of the payment.
In Rev. Rul. 85-98, the IRS emphasized that the complaint is the key document in determining the tax treatment of any recovery. Each cause of action within the complaint should be analyzed to assess the tax implications. For settlements and judgments, the central question is, “in lieu of what were the damages being awarded?”
As seen in the Getty case, had the plaintiff’s father revised the trust in accordance with her oral promise, the plaintiff would have received the promised amount tax-free under IRC Section 102. The absence of this provision in the trust and the subsequent settlement with the trustee to fulfill the oral promise did not affect the tax treatment under IRC Section 102.
Navigating the tax implications of trust litigation settlements can be complex, but it is essential for all parties to draft settlement agreements carefully to ensure that the tax treatment can be properly substantiated and defended if challenged. Understanding the different types of damages and their tax consequences enables litigants to make informed decisions and potentially minimize their tax burden. Engaging experienced legal and tax professionals early in the litigation process is critical for achieving the most favorable income tax outcome.
Trust litigation is often complex and emotionally challenging, especially for beneficiaries and trustees during the trust administration process. One often overlooked but critical aspect of trust litigation is the taxation of judgments and settlements, which can substantially impact the final amount beneficiaries receive. Being aware of the tax implications associated with different types of settlements is essential for beneficiaries to make informed decisions throughout the litigation process.
Under Section 61 of the Internal Revenue Code (IRC), gross income generally includes “income from whatever source derived” unless specifically exempted by a specific statute or case law. Most notably, it is important to distinguish between recoveries from physical injuries and those from non-physical injuries, such as trust litigation or business litigation recoveries. Regardless of whether the damages result from a judgment, arbitration judgment, or settlement, for tax purposes, the principles remain the same.1 Here is a brief overview of the tax treatment for different types of litigation recoveries.
One of the most instructive cases in the tax treatment of trust litigation settlement recoveries is Getty v Commissioner2 (913 F.2d 1486 9th circuit 1990). In this case, Ronald Getty was the beneficiary of an irrevocable trust established by his father, J. Paul Getty, and his grandmother, providing him with income for life, with the remainder to his children and descendants. The trust also benefitted his three half-brothers, who received three times more income than Ronald. Though Ronald’s father promised to remedy the unequal distributions between Ronald and his brothers, no changes were made to the trust before his father’s death.
Following his father's passing, Ronald brought suit — not to contest the will or directly claim from the estate — but to establish a constructive trust over assets transferred to the Getty Museum from his father’s estate, claiming this would equalize what he should have received if his father had fulfilled his promise. The case was settled, and Ronald received $10 million from the Museum. However, he did not report this amount as taxable income, asserting that it was excludable as an inheritance under IRC Section 102(a).
The IRS disagreed and assessed a deficiency, leading to Ronald's argument that the funds should be treated as a nontaxable inheritance. This case is a pivotal example of how settlements in trust litigation can hinge on the interpretation of inheritance exclusions under the tax code.
The Tax Court initially ruled in favor of the IRS, ruling that the settlement Ronald Getty received was taxable as income. However, the 9th Circuit Court of Appeals overturned this decision, ruling that the settlement qualified for income exclusion under IRC Section 12(a). The appellate court took a broader view of Ronald’s claim, interpreting it as a request from J. Paul Getty’s estate in an amount equivalent to what his siblings had received.
Additionally, the court stated that it was not necessary for Ronald to establish that his father would have fulfilled his promise through a direct bequest. The court reasoned that if J. Paul Getty had “kept his promise, he would have done so by a bequest of property, probably of Getty Oil stock.” As a result, the court found that the settlement could be excluded from Ronald's taxable income.
The “Origin of the Claim” test, developed through case law, is used to determine the tax treatment of amounts received from a judgment or settlement to the recipient of such recovery.3 By examining the origin and nature of the underlying claim, the test helps establish:
This test ensures that the tax treatment aligns with the fundamental nature of the claim rather than the structure of the payment.
In Rev. Rul. 85-98, the IRS emphasized that the complaint is the key document in determining the tax treatment of any recovery. Each cause of action within the complaint should be analyzed to assess the tax implications. For settlements and judgments, the central question is, “in lieu of what were the damages being awarded?”
As seen in the Getty case, had the plaintiff’s father revised the trust in accordance with her oral promise, the plaintiff would have received the promised amount tax-free under IRC Section 102. The absence of this provision in the trust and the subsequent settlement with the trustee to fulfill the oral promise did not affect the tax treatment under IRC Section 102.
Navigating the tax implications of trust litigation settlements can be complex, but it is essential for all parties to draft settlement agreements carefully to ensure that the tax treatment can be properly substantiated and defended if challenged. Understanding the different types of damages and their tax consequences enables litigants to make informed decisions and potentially minimize their tax burden. Engaging experienced legal and tax professionals early in the litigation process is critical for achieving the most favorable income tax outcome.
