Damages and interest from stray voltage suit are ordinary income

James A. Beavers, CPA, CGMA, J.D., LL.M.

A district court held that a jury award of tort damages and interest a cattle and dairy farmer received in a stray voltage lawsuit were ordinary income.

Background

Russell Allen had a cattle business and dairy farm in Wisconsin. From 1976 to 2000, his farm was plagued by stray voltage from the lines of the electric utility, Wisconsin Public Service (WPS). In 2000, Allen filed a suit against WPS, alleging damages in the form of decreased milk production, injury to his dairy herd, real and personal property damage, lost value in the use and enjoyment of his property, lost profits and income, veterinary and other expenses, and other damages and injuries. Allen's complaint in the case also alleged that WPS's stray voltage was a nuisance that had caused damages.

At trial in the suit, Allen did not provide specific evidence or details regarding the injuries he suffered, the expenses he incurred, the value of his dairy farm before the stray voltage problem began, the farm's devaluation over time, or his basis in the farm. Rather, he presented an expert witness who testified regarding the economic damages that he had suffered due to the stray voltage. The expert testified that, after inflation, Allen had suffered almost $14 million in damages. As well as economic damages, Allen's lawyers also asked the jury to award compensatory damages (which the lawyers referred to as tort damages) for annoyance, inconvenience, and loss of use and enjoyment of his property.

While the jury decided in Allen's favor, it was less generous than his lawyers would have wanted. The jury returned a special verdict awarding Allen $1,750,000, allocating $750,000 to economic damages and $1,000,000 to tort damages. After the award was affirmed on appeal, Allen received a $2,269,233.35 payment from WPS during tax year 2005 consisting of the $750,000 economic damages award, the $1,000,000 tort damages award, and $519,233.35 in interest that had accrued while the appeal was pending. Out of this, Allen paid his lawyers $1,230,384 in fees, costs, and expenses.

On his 2005 return, Allen reported the $750,000 economic damages as ordinary income on Schedule F, Profit or Loss From Farming, and the $519,233.35 interest on the damages award as capital gains income on Schedule B, Interest and Ordinary Dividends, and $548,736 in legal expenses as farm business expenses on Schedule F (although that amount did not include all legal expenses he paid during tax year 2005). Allen did not, however, report the $1,000,000 in tort damages.

The IRS audited Allen's return. In its deficiency determination, it treated the $750,000 economic damages, the $1,000,000 tort damages, and the $519,233.35 interest award as ordinary income, but it also included all of his legal expenses of $1,230,384 as farm business expenses.

After paying the additional liabilities, Allen filed an amended 2005 return, claiming a refund of $130,215. The amended 2005 return included $119,408 of his legal expenses as an itemized deduction and categorized the $519,233.35 interest award as capital gains income and the $1,000,000 tort damages as a nontaxable recovery of capital. The IRS disallowed the refund claim, leading Allen to file a refund suit in district court.

The district court's decision

The district court held that Allen's interest award and the tort damages from the stray voltage suit were ordinary income. The court further held that the interest award was subject to self-employment tax.

Interest award: The IRS argued that the interest award was compensation for the loss of use of money, and, as compensation, it should be taxed as ordinary income. The court noted that under Tax Court precedent, even interest on a nontaxable award of personal injury damages constitutes ordinary income. In his brief in opposition to the IRS's motion for summary judgment, Allen made no argument that the interest award should be treated as a capital gain, so the court found he had failed to rebut the IRS's determination that the interest award was ordinary income.

Allen did, however, contend that the IRS improperly characterized the interest award as self-employment income arising out of his farming operations that was subject to self-employment tax. He argued that the instructions to Schedule F do not include interest on a list of several types of income that should be treated as farm income on that form and, therefore, treating the interest as self-employment income would be appropriate only if he were a "professional litigant."

The court disagreed, explaining that self-employment income is the net income derived from a trade or business carried on by an individual and that income is derived from a trade or business when there is a nexus between the income and the trade or business. Finding that Allen had failed to cite any authorities that suggested that the IRS had improperly determined that a nexus exists between interest on an award of damages for business losses and the underlying business itself, the court determined that the IRS had correctly treated the interest award as self-employment income.

Tort damages: The court stated that when assessing whether an award of tort damages should be classified as ordinary income or capital gains, courts apply the origin-of-the-claim doctrine, under which the classification of the award is based on the origins and characteristics of the underlying claim, or, in other words, the classification of the award is based on what the award is made in lieu of.

The IRS argued that the court should sustain its determination that the tort damages were ordinary income because Allen presented no evidence during the stray voltage suit trial regarding damages to his real property in support of his nuisance claim. Allen argued that the tort damages must be considered to be compensation for his interest in his farm's real estate capital because he had also received an award of economic damages. According to Allen, his nuisance claim sought compensation not for unrealized cash flow but for the stray voltage that interfered with his real estate, a physical capital asset.

The court agreed with the IRS, finding that the facts in the case showed that the tort damages for his nuisance claim were awarded in lieu of lost profits and were therefore ordinary income under the origin-of-the-claim doctrine. The court noted that Allen had presented no evidence at the stray voltage suit trial regarding the original value, the basis, or the diminution of value of his real property; rather, his evidence focused on his economic damages — his lost profits from milk production and the sale of dairy and beef cattle. Moreover, Allen's lawyers told the jury to base the amount of the tort damages it awarded on the claimed amount of economic damages. Therefore, Allen had failed to show that he sought a recovery for interference with his real property as a capital asset.

Reflections

The court also upheld the IRS's imposition of an accuracy-related penalty under Sec. 6662. Allen argued that he made a good-faith effort to report his income tax liability for 2005 and should thus be excused from the penalty, but the court had trouble reconciling his omission of the $1 million in tort damages with a good-faith effort to report his income, especially since Allen rejected advice from the accountant whom he had originally asked to prepare the return.

Allen, No. 16-C-1412 (E.D. Wis. 2018)

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