Foster v. U.S.

• Decision Date: 13 March 2000
• Docket Number: No. CV 99-P-1838.,CV 99-P-1838.
• Citation: 106 F.Supp.2d 1234
• Parties: Mattie FOSTER, Plaintiff; v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — Northern District of Alabama

106 F.Supp.2d 1234

Mattie FOSTER, Plaintiff; v. UNITED STATES of America, Defendant.

No. CV 99-P-1838.

United States District Court, N.D. Alabama, Southern Division.

March 13, 2000.

Order Denying Motion to Amend, March 29, 2000.

J Donald Hughes, Bradley Arant Rose & White, Birmingham, AL, for plaintiff.

G Douglas Jones, U.S. Attorney's Office, Birmingham, AL, Paul G Gill, Thomas E Scott, U.S. Department of Justice, Tax Division, Ben Franklin Station, Washington, DC, for defendant.

OPINION

POINTER, District Judge.

Mattie Foster brought this action seeking a refund of $237,139.00 (plus interest and attorney's fees) for overpayment of income taxes, penalties, and interest for the calendar year 1994. By amendments to the complaint, Foster also seeks damages under IRC § 7433, premised upon the collection of taxes that, she alleges, were erroneously assessed. The United States has moved for summary judgment with respect to the tax refund claim and has moved to strike and to dismiss the § 7433 damage claim. The three motions are under submission after extensive written briefs and oral argument. All of the issues appear to be ones of law, not involving genuine disputes with respect to any material facts.

This controversy arises as a result of the collection of a state court judgment rendered in Foster's favor against Life Insurance Company of Georgia ("Life of Georgia"). In that case, Foster had charged Life of Georgia with fraud in selling her a Medicare supplement insurance policy that was essentially worthless because she did not have Medicare coverage. After a jury trial and an appeal, the Alabama Supreme Court upheld an award to her of $50,000 in compensatory damages — consisting of $95 in damages for a disallowed claim for medical expenses under the policy, of $2,468.60 in damages for the premiums paid for the policy, and of $47,436.40 as damages for emotional distress and mental anguish — and of $1,000,000 in punitive damages. Foster v. Life Ins. Co. of Georgia, 656 So.2d 333 (Ala.1994). This award, plus $156,032.80 in post-judgment interest, was paid in 1994 through a single check issued by Life of Georgia jointly to Foster and her attorneys. Consistent with their fee arrangement, the attorneys then paid Foster $525,000, which was 50% of the amount of the judgment.

Foster did not report in her federal income tax return any portion of this recovery as gross income (nor did she claim any portion of the attorneys' fees as a deduction). In 1997 the Internal Revenue Service assessed — and then, through levy on an annuity policy purchased by Foster from proceeds of the judgment, collected — a tax deficiency for 1994, calculated by treating the punitive damages and interest portions of the amount paid by Life of Georgia as Foster's gross income, though allowing amounts retained by her attorneys as an itemized miscellaneous deduction. After the denial of Foster's claim for a tax refund (in which she did not challenge the inclusion in gross income of interest on the judgment), this current action was filed.¹

I. Tax Refund Claim.

Foster concedes that interest on the judgment would be reportable as gross income, subject to an issue regarding treatment of attorney's fees. She contends, however, that the balance of the recovery did not have to be included in gross income because of § 104(a)(2) of the Internal Revenue Code of 1986. That section, as it read in 1994 (and, indeed, had read with only one minor change since 1918), excluded from gross income "the amount of any damages received ... on account of personal injuries or sickness." Foster's argument for exclusion of punitive damages emphasizes a 1989 amendment that added at the end of § 104(a) this language: "Paragraph (2) shall not apply to any punitive damages in connection with a case not involving physical injury or physical sickness." Relying upon Cotnam v. Comm'r, 263 F.2d 119 (5th Cir.1959), Foster also contends that the amounts retained by her attorney under their fee agreement should reduce — "dollar-for-dollar" — any amounts otherwise reportable in her gross income, rather than merely be allowed as an itemized miscellaneous deduction.²

The United States concedes that at least the major portion of the $50,000 compensatory damages award is not to be included in Foster's gross income.³ But it contends that, under O'Gilvie v. United States, 519 U.S. 79, 117 S.Ct. 452, 136 L.Ed.2d 454 (1996), the punitive damages portion of the recovery from Life of Georgia is (together with the interest on the entirety of the judgment) to be included in her gross income. And it argues that Cotnam is simply wrong in holding that amounts withheld from a recovery by an attorney under Alabama's attorney lien statute reduce a taxpayer's gross income.⁴ It contends that such payments merely qualify for treatment as an itemized miscellaneous deduction incurred in the production of taxable income.

It is clear that —

• If the pre-1989 version of § 104(a)(2) of the Internal Revenue Code of 1954 governed this case, the punitive damages portion of the judgment would, because of the Supreme Court's 1996 decision in O'Gilvie interpreting that provision of the Code, have been reportable as Foster's gross income (subject to the question of how attorney's fees are to be treated).

• If the 1996 revision of § 104(a) had been in place in 1994, the punitive damages — and, indeed, most of the compensatory damages — would, because of the clear statutory language,⁵ have been reportable as Foster's gross income (subject to the question of treatment of attorney's fees).

The question regarding taxation of punitive damages arises because of the language added to § 104(a) by the 1989 amendment.

In O'Gilvie, the Supreme Court concluded that the recovery of punitive damages — even in a wrongful death case — did not constitute damages received "on account of" personal injuries such as to qualify for exclusion from gross income under § 104(a)(2). The language of § 104(a)(2) in effect in O'Gilvie was still the same in 1994, when Foster's judgment against Life of Georgia was collected. The 1989 amendment to § 104(a) did not create an additional exclusion from gross income or expand the exclusion afforded under § 104(a)(2). Rather, it attempted to make clear — at a time when, before O'Gilvie, the law was uncertain — that there would be no exclusion from gross income of punitive damages in the absence of "physical" injuries. Because the 1989 amendment at most only limited the potential reach, and did not expand the exclusion, of § 104(a)(2), there is no reason to speculate on whether — if the dissent in O'Gilvie had been adopted as the Court's decision — Foster's 1994 punitive damage recovery would nevertheless have constituted gross income because her compensatory damages were arguably not damages for "physical" injuries under the 1989 amendment.

Having concluded that the punitive damages were subject to inclusion in gross income, the court next turns to the question of the proper treatment of the attorney's fees. The contingent fee agreement between Foster and her attorneys, entered into before her action against Life of Georgia was filed, called for a 50% division of "all sums collected." It also provided that all costs and expenses incurred in the preparation and trial of her case would be paid by Foster "upon demand,"⁶ and that "if for any reason this matter is appealed ... a fee for appellate services will be negotiated at that time."

Under Cotnam, a pre-split Fifth Circuit decision binding on this court, the fee agreement had the effect of an assignment by Foster to her attorneys — without realizing income then or later — of a fifty percent share in her speculative chose-in-action, with the consequence that, when later there was a successful pursuit of that claim, Foster was subject to potential taxation only with respect to her remaining fifty percent share of the recovery. In the present case, it is appropriate to apply Cotnam by treating Foster as having assigned to her attorneys, through the contingent fee agreement, half of her claim for punitive damages, half of her claim for compensatory damages, and half of any claim for post-judgment interest. See also Estate of Clarks v. United States, 202 F.3d 854 (6th Cir.2000); Davis v. Comm'r, T.C. Memo.1998-248, 1998 WL 373342 (July 7, 1998). What this means is that Foster's 1994 gross income does not include her attorneys' half of the punitive damages ($500,000) or her attorneys' half of the interest ($78,016.40) ultimately paid by Life of Georgia.

As noted above, the initial fee agreement provided that, in the event of an appeal, a fee for appellate services would be negotiated at that time. After the jury returned its verdict — awarding Foster $1,000,000 in punitive damages and $250,000 in compensatory damages — the trial judge entered a judgment for the compensatory damages but, because of a legislative "cap," reduced the punitive damages to $250,000. There were then cross-appeals by both Foster and Life of Georgia. A few months later, in June 1993, the Alabama Supreme Court in another case, Henderson v. Alabama Power Co., 627 So.2d 878 (Ala.1993), declared unconstitutional the legislative cap on punitive damages. In January 1994, the Supreme Court reinstated Foster's $1,000,000 punitive damage verdict, but ordered a conditional remittitur to $50,000 of the compensatory damage verdict, which she subsequently accepted.

The agreement negotiated between Foster and her attorneys at the time of the appeals was that the attorneys' fees for appellate services would also be contingent upon their success. The agreement was that, as the fee for such services, the attorneys would be entitled to all of the post-judgment interest ultimately collected, if any, rather than only to the 50% previously assigned under the initial agreement for services at the trial level. In this tax case, Foster contends that the additional amount ($78,016.40)...