Case Conclusion Date: 07.22.1985
Practice Area: Business
Outcome: Ruling in our favor, a huge income tax benefit
Description: Peter was the President of a small manufacturing company and acted as the General Manager of its operations. His wife, Helen, was the Executive Vice President and was responsible for all of the Companyâ€™s financial and administrative matters. While training plant personnel on the use of a new machine, Peter's sweater sleeve got caught and his arm was pulled into the machine. As a result, Peter suffered serious injury which required surgery and it was likely that Peter would suffer some permanent loss of some use of his arm. I counseled Peter to put in a claim against the Corporation for damages and retain a personal injury lawyer to handle his grievance. A very substantial settlement was negotiated. I recommended that the Company deduct the settlement payment to Peter as a legitimate income tax expense under Section 162(a) of the Internal Revenue Code and that Peter exclude the receipt of the payment on his income tax return under Section 104(a)(2) as compensation received on account of personal injuries. The IRS subsequently audited both the Company and Peter and Helenâ€™s personal Tax Returns. They argued that the payment from the Company to Peter was a disguised dividend and, therefore, not deductible by the Company and not excludable from Peterâ€™s income. Peter and the Company vigorously objected to the IRS position and I fought the battle for them in the US Tax Court. The IRS' position was based on the fact that the transaction in question was between a closely held corporation and its President who along with his wife, Helen, were the controlling shareholders. Obviously, Peter and the Company were not dealing at armâ€™s length. This engendered a greater burden on Peter and the Company to show the legitimacy of the transaction. Corporations, by definition are independent entities, separate from the owners, so I argued that the Court should compare the actions of Peter and the Company with what would have occurred if the transaction was at armâ€™s length. If Peter had been an employee of the Company without a controlling share and had suffered this injury, he more than likely would have hired an independent attorney to pursue his claim, just as I recommended Peter do. The Companyâ€™s attorney and Peterâ€™s personal injury attorney would have negotiated a reasonable settlement just as they did. In closing arguments to the Court, I stated that the decision should be based on whether there was a reasonable basis independent of tax considerations for the Company to deduct the settlement payment and for Peter to exclude it as compensation for personal injuries. The fact that Peter was a controlling shareholder of the Corporation should not disqualify him from the reasonableness of receiving a tax free settlement under the law which allows for the same. The IRS attorney finished his closing remarks by stating that the whole transaction was just a manipulated tax saving scheme. My retort was that the obvious inference of the IRS argument was that Peter intentionally stuck his arm in the machine and suffered the grievous injury on purpose. I told the Judge that this would truly be â€œtax planning with a vengeanceâ€. The Judge ruled in our favor and Peter and his Company were able to receive a huge income tax benefit. The moral of the story is that Peter and his Company had the proper tax and legal advice which included a very practical and well thought out plan. Of course, the preparation of a compelling brief to the Tax Court along with a winning trial presentation and closing argument were critical. There is, obviously, no substitute for creative and well thought out tax strategy followed by the implementation of a very specific and practical plan. As an aside, a few weeks after the issuance of the written of opinion by the Tax Court, Time Magazine ran a short article on the case. As another aside, the IRS counsel on the case, who is currently in private practice, now refers me clients.