In the news this morning are the reports that the San Diego Archdiocese has joined the many other Catholic Church's from around the country in finally resolving the pending sexual abuse claims against it. Obviously we will be treated to the now standard news stories of the bishop's saying they hope this closes an ugly chapter in the church's history and that this allows healing of the victims to begin. We will also see the tearful reactions of the victims, some of whom were molested or raped over 50 years ago and who have suffered for decades with the emotional and mental trauma so common to people who were horrifically abused by trusted spiritual and authority figures.
While $200 million is a very large sum, I am sure that to the 144 members of this group it is still a minor consolation for the decades of pain they have endured, and the frustration and indignity that is the legal process of trying to obtain justice for wrongful acts. However, our system and society measures justice in dollars very often, so this large sum is certainly vindication in some measure, if not justice.
So why do I say justice is denied? I say that because as I've written here on my blog as well as spoken in our podcasts these awards are almost certainly fully taxable to these victims as a result of the Murphy vs IRS decision earlier this summer. I know there are a lot of tax commentators and settlement advisors who don't want to be the bearer of this bad news, but there is really no other way to read Murphy and I can't imagine a life insurance market accepting one of these structures as tax qualified under section 104 or section 130 of the IRC.
To further add salt to the wounds of these people, the Banks and Banantis decisions at the US Supreme Court made it abundantly clear that the legal fee these people owe their attorneys, whom it appears have done a magnificent job, is NOT tax deductible and is fully included in the taxable income of the abuse settlement victim. What this means is not only are they going to be taxed on what they receive, they are also going to be taxed upon what their ATTORNEY receives.
My question to the settlement and legal community is this; How in the world have we as an industry and the trial lawyers as a profession allowed this horrific injustice to continue for 11 years, or since the amendment of the section 104 in 1996? We have danced around this, made legal and tax arguments, constructed foolish arguments that molestation can be construed as a physical injury when it clearly can not be in the eyes of the IRS and generally avoided the reality that the only solution of this insane tax policy is a legislative solution. Lets look at the facts of the "average San Diego settlement victim as to what they will receive if they take their award in cash:
Based on the number of claimants and the published amount the average award before fee's and expenses deducted would be approximately $1,375,000, although the paper reports some will be higher and some will be lower based upon what the judge decides. Now remember, the legal fee's are NOT tax deductible and the entire award will be subject to AMT treatment, thus wiping out a lot of deduction's you might typically use to mitigate the tax event. So lets assume we have this average client at the highest marginal federal income tax rate of 35%, and the highest California residential income tax rate of 10.3% for a combined rate of 45.3%. Using the simplest of calculation that means this abuse victim is going to have a state and federal tax bill of $622,875, leaving them a net of $752,125. Not bad you say? Well, lets remember that the legal fee is going to be a percentage of the PRE-TAX amount, typically 33% but in many cases such as this as high as 40% given the difficulty and complexity of winning. So, lets use the lower amount and do the math again. $1,375,000 at 33% would total a legal fee of $457,875. Throw in some allocated case expense of about $10,000 per claimant on average and the "average" recipient will be looking at a net award of $284,250. Thats right, after taxation and legal fee's this "average victim" is going to be turning over $1,100,000 back to his attorneys and the tax man.
Is that Justice? No, but it's a fact and one of the bigger scandals in the US tax code continues on and on with abuse victims, the wrongfully imprisoned, the defamed, the wrongfully terminated and discriminated enduring confiscatory levels of double taxation that no other class of victim or taxpayer in the US tax code has to suffer under. Just this last week I had the State of Texas refuse to do a structure on a wrongful imprisonment case that would have provided huge tax relief to a plaintiff solely on the grounds that " we don't make payments to assignment companies". While that may or may not be the state's position that was the mind set of the attorneys for the state and it sufficiently frustrated the trial lawyer that they just gave in and did what the state told them they had to do. Who can blame them? Which leads me to my next point.
That being that to me the bigger scandal is that trial lawyers have utterly failed to educate themselves and their clients as to the tax status of non-physical injuries and as a result have failed to take even the most basic steps to mitigate the tax impact for their clients through the use of 468b settlement funds, structured legal fee's and non-qualifed structured payments. How in the world can any attorney working on taxable damage cases not have a 468b settlement trust, prior tax planning for the client and mitigation of the tax impact through structured legal fee's is almost beyond belief to me, but I see it in case after case with some of the finest trial lawyers in America. The lack of education and awareness on this topic should be a matter of shame for every state trial lawyer association that has failed to write or speak on this topic to their membership. I'll be doing a post this weekend on what a trial lawyer should do if faced with a taxable case so as to provide the maximum relief to his client and to make sure they know what their options are.
Finally, if you are an award recipient I urge you to locate a settlement professional to assist you in deciding what your options are as to the income and tax planning of these moneys. You get once chance, your best planning occurs before you get the funds and you really need to know your options so that you don't make unwise or uninformed decisions. An annuity payout is likely to be your very best option so make sure a competent professional is working on your behalf.