Legal malpractice claims can arise out of any type of law. In a successful legal malpractice case, the plaintiff will recover some amount of money from either the lawyer who made the mistake, or from the lawyer’s malpractice insurance carrier.
The question is: how does the plaintiff report the money on their personal income taxes? Is the recovery ordinary income? Is it capital gains? Or is it simply not taxed at all?
Although a number of commentators, (notably, Robert W. Wood of Wood & Porter in San Francisco,) have written on this subject in past years, the courts and the IRS have yet to come to any conclusion on how to treat these types of cases. In general, the theory governing legal malpractice recoveries is known as “origin of the claim.”The idea is that if recovery for the underlying claim would not have been taxable, then a recovery based on legal malpractice arising from the underlying claim is also not taxable.
The typical example of this theory occurs in physical injury cases. If Scooby sustains injuries from a drunk driver and receives damages, that recovery is not taxable under Section 104(a) of the Internal Revenue Code. What if instead, Scooby’s lawyer misses a deadline and Scooby’s case gets thrown out? Scooby sues the lawyer for damages, and recovers. The “origin of the claim” against his lawyer is the physical injury from the drunk driver. Because that type of recovery is not taxable, neither is the recovery from the lawyer.
In the area of estate planning, a typical scenario would be if a beneficiary were inadvertently left out of a decedent’s will. For example, suppose that Fred has a $1,000,000 estate. He meant to leave it equally to his two children, Daphne and Velma. Fred’s lawyer, however, makes a mistake when drafting the will and Daphne gets everything after he dies. Velma contests the will, claiming that she was supposed to get half. If she wins, how should she report her $500,000 on her personal taxes?
Unfortunately, there is no clear cut answer. It depends on the origin of the claim. You have to consider the nature of Fred’s estate and his intentions regarding what kind of property he wanted to give to Velma. Under Section 102(a) of the Internal Revenue Code, if the property received is a gift, bequest, devise or inheritance, it is not taxable and Velma doesn’t have to report it. If, however, Fred meant to give Velma an income stream from the property instead of the property itself, then Section 102(b)(2) states that the money would be included in Velma’s gross income.
Velma has to look to the nature of the underlying property to determine whether or not what she recovered from the lawyer is going to be taxable.The main point to note in this area of income taxation is that not every recovery is treated the same, and the IRS and courts have yet to affirmatively agree on how legal malpractice awards should be taxed. We will continue to monitor any developments in this area of the law for our clients.
Julie R. Lackner, Esq.