LA Diocese abuse settlement and taxable damages after the Murphy vs IRS case. Boy have we got a problem.

In major news on a particularly slow news week, it was announced late Friday that the Archdiocese of Los Angeles had finally reached settlement on what will now become the largest single payout on the sexual abuse cases that have plagued the Catholic church since these first broke in Boston back in 2000. The total of $660 million agreed upon the eve of trial, covering 508 claimants, breaks out to approximately $1,300,000 per claimant, definately the largest average pay out of any of the settlements so far. As a comparison, the Boston case paid only about $160,000 per claimant before fees and expenses, so you can quickly see the relative the magnitude of this settlement compared to other abuse settlements listed in the graphic below.

You can read AP press accounts on the Los Angeles Archdiocese settlement by clicking here.

The Los Angeles Daily News story on the LA Diocese settlement. 

An in-depth story on the entire case and history of the LA Archdiocese settlement by the LA Times is available here. 

For a glimpse at the depth of the problem this has been for the US Catholic church, check out this graphic that was part of the LA Times story, which illustrates the number of plaintiffs, and amounts of settlement, for all the abuse cases settled since 2002. Please note that the recent settlement for LA does not include a separate settlement of approximately $82 million dollars agreed to by certain other Catholic orders settled prior to yesterdays settlement.

Major clergy abuse settlements nationwide since 2002


Number of

Settlements

Archdiocese/Dioceseclaimants(in millions)
Los Angeles570+$764
Boston983$157
Portland, Ore.315+$129*
Orange90$100
Covington, Ky.350+$85
San Francisco113$73**
Oakland56$56
Spokane, Wash.175$48
Tucson60$36
Sacramento33$35
Louisville, Ky.250+$30
Hartford, Conn.44$23
Milwaukee10$17



* Includes $23.8 million set aside for future claimants.
**San Francisco's payout includes pre-2002 settlements.
Note: Exact terms of all settlements have not been disclosed or are not final.
Graphics reporting by Gale Holland and Vicki Gallay,Los Angeles Times

Great reporting by the LA Times, and a superb job by the trial lawyers handling this complex, emotional and difficult case. However, now lets talk about that which is not spoken of in these sex abuse cases, and that is the issue of taxation on the damage claim, non-deductibility of legal fees and whether or not structuring settlements out of a 468b QSF is being considered for these clients. I'll be covering this complex topic in a series of blog posts. 

First, lets tackle the issue of taxation on sexual abuse cases and claims first, particularly in light of the recently decided Murphy vs IRS decision that makes quite clear that damages, as described in the 1996 amendment of section 104(a)(2) of a non-physical nature, such as emotional distress, wrongful imprisonment, etc, are going to be fully taxable and as such can not be structured tax free, or paid tax free unless there is a physical injury or sickness.

In my recent podcast with nationally renown expert Attorney Robert Wood, of the Wood & Porter law firm in San Francisco, CA., we discussed the Murphy vs IRS decision on taxable damages, and had touched upon the sexual abuse case issue, not realizing that two days after the podcast the LA Diocese case would make such headlines. Essentially Rob believes, as do I, that the settlement of most, but not all, sexual abuse cases could potentially result in a fully taxable event given the guidelines and opinions one hears from the IRS on this topic, and based on the very plain language provided by Murphy vs IRS by Judge Ginsburg regarding the distinction as to what constitutes a qualifying physical injury case. 

You can read the Murphy v IRS decision by clicking here. I will also be posting Attorney Rob Wood's extensive article and commentary on this once it has been published and is available online. 

You can listen to my entire podcast with Rob Wood on taxable damage cases post Murphy vs IRS by clicking here as well as our brief commentary on sexual abuse and molestation cases and their potential taxation issues.

What makes these cases such a difficult and taboo topic in the settlement world is the generally open secret that for the last 5 or 6 years many plaintiffs in other sexual abuse and molestation cases have taken a position that, because there was physical touching, penetration, physical force and coercion that this some how falls under they physical injury wording in section 104, and that a plausible case can be made to the IRS if examined that the damages qualify as tax free vs taxable. Basically, up until just last week with the Murphy v IRS decision, the advice given has been that it pays to be somewhat aggressive in your tax stance, with the belief that the IRS isn't likely to want to audit the returns of such a tragic and sympathetic group of plaintiffs and potentially disallow their tax free damages. As someone who has professionally handled many rape, abuse and molestation settlements over the last 20 years, several of which were quite high profile, I've had to navigate this difficult issue on many occasions and try and attempt to find a tax approach that conformed with the shifting tides of tax opinion and law on this complex cases.

That said, and while I have great regard for the tax and settlement professionals who take this more aggressive posture on the matter of the definition of what is physical injury, I personally and professionally have now come to the conclusion that given the Murphy vs IRS decision, it is exceptionally dangerous to assume that any abuse or molestation case is tax free under section 104(a)(2). Any plaintiff, trial lawyer, settlement professional or life company that decides to approach these as qualifying under section 104(a)(2) post Murphy is in my opinion taking a serious risk of reversal by the IRS at some future point.

So, if these case are now taxable under this new tax landscape, what are the plaintiffs and their attorneys to do when it comes to their settlement options and net pay outs on these cases? This shift in tax policy is going to dramatically impact trial lawyers, life companies and plaintiffs when the subject of structured settlements is considered for these cases.

First, lets take that average settlement of $1,300,000 and look at the factors these people are now going to be forced to deal with on taxation, given the Murphy vs IRS decision, coupled with the previously settled Banks and Banatis Supreme Court decisions from two years ago on deductibility of legal fees on taxable damage cases. 

The first nasty surprise everyone is going to be in for is that the entire award, the $1,300,000 average payout, is going to be fully taxable to the claimant, despite the fact the trial lawyers in this case will of course take their customary fee of somewhere between 30% to 40% of the amount, thus leaving the claimant with about $800,000 in actual cash in their hands after fees, expenses and such are calculated and paid. However, what most people still don't quite comprehend is that the tax payer is going to have to report the full $1,300,000 in taxable earnings, while not being allowed to deduct the $500,000 in legal fees and expenses that are incurred and paid. This patently unfair application of the tax law as it is written, was at the heart of the argument in Murphy, and had also been argued for many years but ultimately resolved against the interests of plaintiffs in the Banks and Banatis Supreme Court cases. People in our industry and the trial bar have got come to grips with the fact that It's no longer a matter of "what if" on taxable cases, but that it is now largely settled law and policy as to the treatment of non-physical injury cases and the non-deductibility of attorneys fees. Those are the rotten, miserable facts if you are a recipient of an award for abuse or molestation, but it is important that all parties involved face up to this and begin to deal with them and look for options that provide tax relief.

So in our example, our abused plaintiff in this illustration, now will have to report $1,300,000 of taxable income in 2007. Under California and Federal tax rates, this would result in a maximum tax rate where they are paying 35% on their amount in excess of $336,000 to the Feds, and 9.3% on the amount in excess of about $46,000 to the state of California. This is a combined rate of 44.3% on the top marginal dollars of this award. Now, I'm not a CPA and I know all about deductions, sliding effective rates, etc, but this is just a rough calculation right now so bear with me here. Why this is so important is that means that for the typical plaintiff, they are probably going to be facing, after deductions and exemptions, a tax hit on the entire $1,300,000 of about $500,000 if they are residents of California, which most of these plaintiffs probably are.

Now, lets do the rest of the painful tax math. The $1,300,000 awarded to the plaintiff, less a legal fee of around $500,000, leaves an initial net to the plaintiff to approximately $800,000. Next, lets pay our tax bill of around $500,000 and what our abused victim is left with is something closer to $300,000 after all fees, expenses and taxes are paid. Yes, you are reading that correctly, and if it's making you sick or angry it should. This is what the courts and the IRS have determined is the lot for non-physical injury cases victims, a 77% hair cut on their award simply because their damages fall outside the protective definition of section 104(a)(2). If you are angry or upset, you need to contact your US congressman and Senator and ask them why there has been virtually no action on several pending bills, particularly, one sponsored by Arlen Spector (R) Pennsylvania that would help correct this problem.

Now that we have framed the tax problem in rather stark terms, I'm going to end part one of this discussion on taxable damage cases here, and pick up again tomorrow with part two of this three part blog analysis of the tax, legal and settlement planning issues facing sexual abuse and molestation claimants. Part two will discuss the tax implications for the trial lawyers if they elect to take their fee's on these cases in a lump sum, and how using a structured annuity would provide substantial tax relief to their clients. Part three will review the issue of how settlement professionals should approach these cases and provide a ray of hope for plaintiffs in that they can, and probably should, structure most of their damages on these cases using non-qualified structures to spread out the tax hit and reduce the financial impact of having 77% of your award taken in fees, expenses and taxes.

I just hope, and i'm sure given the quality of the attorneys involved in this case that it was done, that a 468b qualified settlement fund was established for these victim's, and that the claims payments will be paid into it so that proper planning and tax deferral can take place for these people who have waited so long for justice on these horrific cases.