If a dairy farmer receives an award for damages to the farm, is the damage award capital or ordinary? The distinction is important. Unlike ordinary income, capital gains are generally afforded lower tax rates and not subject to self-employment taxes. The court considered this fact pattern in Allen v. United States, No. 16-C-1412 (E.D. Wis. 2018).
Facts & Procedural History
The taxpayer is a dairy farmer. He brought a civil suit against his local electric company. The suit sought damages for:
decreased milk production, injury and damage to his dairy herd, has suffered property damage, real and personal, has lost value in the use and enjoyment of his property, has lost profits and income, has incurred veterinary and other expense, and has been otherwise damaged and injured
related to stray voltage on his dairy farm.
The taxpayer agreed that the civil suit was not a claim for personal injury and no medical evidence was presented.
The jury awarded the taxpayer $1,750,000, allocating $750,000 to economic damages and $1 million to tort damages. The taxpayer was also awarded $519,233.35 in interest that had accrued while the appeal was pending.
The Tax Reporting Position
The taxpayer filed his return and reported the $750,000 economic damages as ordinary income on Schedule F and the $519,233.35 interest on the damages award as capital gains income on Schedule B. He did not report the $1 million tort damages.
On audit, the IRS determined that the tort damages were ordinary income and subject to self-employment tax. Litigation ensued.
The taxpayer changed his position with respect to the tort damages for litigation. The taxpayer’s position was that the tort damages were a nontaxable recovery of capital on Schedule B Form 4797. Put another way, the taxpayer’s position was that the damages were an award for a capital asset.
The Origins of the Claim
The courts have developed the “origin of the claim” doctrine to determine whether an award is for a capital asset. This doctrine considers the nature of the underlying claim.
Although not cited in this case, the courts often cite United States v. Gilmore, 372 U.S. 39 (1963) for this doctrine. Over time, the court cases citing Gilmore expanded to the business versus capital distinction.
In Boagni v. Commissioner, 59 T.C. 708, 713 (1973), the U.S. Tax Court has explained the doctrine as follows:
Quite plainly, the “origin of the claim’ rule does not contemplate a mechanical search for the first in the chain of events which led to the litigation but, rather, requires an examination of all the facts. The inquiry is directed to the ascertainment of the “kind of transaction” out of which the litigation arose … Consideration must be given to the issues involved, the purpose for which the claimed deductions were expended, the background of the litigation, and all facts pertaining to the controversy.
What type of transaction did the instant award arise from? Was it a claim for damage to business profits or to real estate or both? The promise of business income or profits in the future is generally not a capital asset. Real estate is generally a capital asset. Where does damage to a dairy farm fall in this?
Evidence of a Business or Capital Transaction
The courts typically look to the pleadings in the underlying lawsuit in determining whether an award is for damage to a business or capital asset. In this case, the court here noted that the:
original complaint does contain more specific claims regarding the capital nature of his real estate — alleging that he “has suffered property damage” and “has lost value in the use and enjoyment of his property” — the purely economic nature of the evidence ultimately presented at trial diminishes the utility of those allegations from early in the litigation.
This would seem to indicate that at least some portion of the award was for damage to a his real estate, which is a capital asset.
But the court went beyond the pleadings. The court considered the evidence presented in the underlying lawsuit. The evidence consisted of evidence regarding lost profits from milk production, lost sales of young dairy cows, and lost sales of beef cows. It did not include evidence from appraisers, etc. as to the diminution of value of his farm real estate.
Based on this evidence presented during the trial, the court concluded that the tort damages were subject to tax as ordinary income and not capital gain. This saved the court from having to decide what amount of the award was ordinary and what portion capital.
It would seem that this type of claim did reduce the value of the taxpayer’s dairy farm. A future buyer would likely factor this into the amount they would pay for the farm. Did the court err in going beyond the pleadings and focusing solely on the evidence presented in the underlying lawsuit?
Accuracy Related Penalties
The IRS had also assessed accuracy related penalties in this case.
The reliance on a tax advisor is a recognized defense to penalties. But in this case, the evidence showed that the taxpayer did not follow the advice of his tax preparer in reporting the litigation award. The taxpayer did not engage a tax attorney to write a tax opinion letter, so he could not point to that type of advice either (the business vs. capital distinction for litigation awards is one that tax attorneys often write opinion letters for).
As a result, the court sustained the accuracy related penalties.