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Settlement Payment Is Excludable from Income under Step Transaction Doctrine.
(Parker Tax Publishing June 4, 2014)

Where a settlement agreement between a taxpayer and several mortgage lenders resulted in the taxpayer receiving a check for $10,000 from one of the mortgage lenders followed by a requirement to then transmit that amount to the two other mortgage lenders, the taxpayer's receipt of the $10,000 was not taxable income under the step transaction doctrine. Kadir v. Comm'r, T.C. Summary 2014-43 (5/6/14).

Mohammed Kadir owned a home in Brooklyn Park, Minnesota. In August 2006, Mohammed decided to refinance his mortgage to try to lower his monthly payments. As a nonnative English speaker, Mohammed relied heavily on agents at GreenPoint Mortgage Funding, LLC (GreenPoint). He ended up with two mortgages, and GreenPoint originated both. But each of the new mortgages had a different mortgage servicer. The first mortgage for $172,000 used GMAC Mortgage, LLC (GMAC) as its servicer. The second mortgage for $21,500 used Specialized Loan Servicing, LLC (SLS). These two mortgages totaled $193,500. Although Mohammed's purpose in refinancing was to reduce his monthly mortgage payment, once all the refinancing was done, his monthly payments continued to rise. Though he was making "minimum payments" on his mortgages, the people that helped Mohammed refinance failed to adequately explain the concept of a negatively amortizing mortgage. The monthly payment that stops a negatively amortizing mortgage from increasing the principal amount of the debt is often well above the minimum payment that the mortgage requires.

In early 2009, after growing increasingly frustrated when his attempts to understand what was going on with his payments failed, Mohammed stopped making payments. He then sued GreenPoint, GMAC, and SLS, claiming they had lied to him when they promised his payments would go down and that they had made false promises and misleading statements, and had engaged in deceptive practices. In 2010, a settlement agreement was reached under which Mohammed got his debt both interest and principal reduced to what he could afford. In addition, the settlement agreement required GreenPoint to give Mohammed a check for $10,000 and required Mohammed to pay $5,700 to GMAC and $4,300 to SLS from the payment he received from GreenPoint.

As a result of receiving the $10,000 payment, Mohammed received a Form 1099-MISC, Miscellaneous Income, for his 2010 tax year. The 1099-MISC said that the $10,000 payment to Mohammed was nonemployment compensation. GMAC and SLS also sent Mohammed Forms 1099-C, Cancellation of Debt. These forms said that Mohammed had more than $35,000 in canceled debt and that the amount of the cancelled debt was includible in Mohammed's income. Mohammed didn't report either of these amounts. The IRS subsequently sent Mohammed a deficiency notice which stated only that he owed tax on the $10,000 that he received from GreenPoint.

In the Tax Court, the IRS made two arguments. Citing Worsham v. Comm'r, T.C. Memo. 2012-219, aff'd 531 Fed. Appx. 310 (4th Cir. 2013), the IRS argued that settlement proceeds are included in the broad definition of income unless they are damages received on account of personal injuries or sickness. Thus, Mohammed should have included the $10,000 settlement proceeds in income. Second, the IRS argued that Mohammed had cancellation-of indebtedness income as a result of the settlement agreement.

Because the settlement agreement required him to pay a total of $10,000 to GMAC and SLS, Mohammed argued that this provision in the agreement meant that he was like a mailman who picks up an envelope containing a $10,000 check and then delivers it to its final address.

The Tax Court quickly disposed of the IRS's cancellation-of-indebtedness argument, noting that the IRS had not raised that issue until the trial, which made it too late to consider. Thus, the court focused on the issue of the settlement proceeds.

The Tax Court held that the $10,000 Mohammed received under the settlement agreement was not taxable income. When a taxpayer receives money in settlement of a lawsuit, the court said, the question to be asked is: in lieu of what were the damages awarded? See Raytheon Prod. Corp. v. Commissioner , 144 F.2d 110 (1st Cir. 1944), aff'g 1 T.C. 952 (1943) (holding the recovery for damage to business and good will represents a return of capital; the fact that the suit ended in a compromise settlement does not change the nature of recovery). Here, Mohammed sued for the tort of fraud; but according to the court, that alone didn't answer the question of taxability. The Tax Court rejected the IRS's reliance on Worsham because that case involved "silly tax protester arguments" and the court had not meant to make a general rule of when settlement proceeds were taxable; rather, it was deciding only one taxpayer's case.

In the instant case, the court applied the step-transaction doctrine where independent steps are treated as one transaction if the steps are integrated to achieve a specific result. Penrod v. Commissioner , 88 T.C. 1415, 1428 (1987) (discussing the various tests employed in applying the step transaction doctrine and pointing to the importance of substance over form). Mohammed didn't get to just take the $10,000, the court noted. Because the settlement agreement required him to pay $5,700 GMAC and $4,300 to SLS, this meant that the money going to GMAC and SLS was the same money that was paid to Mohammed, all steps toward a particular result. Mohammed had a binding commitment to make those payments. The court was also struck by the fact that the promised payments had no relation to the amounts of the two loans that Mohammed was getting out of, and by the fact that the promised payments were going to GMAC and SLS, and not to Greenpoint. Apparently, GMAC and SLS were very concerned with how the settlement would be divided. The court was convinced that the settlement was intended to get some money from Greenpoint to GMAC and SLS even if $10,000 went into Mohammed's account for a moment.

For a discussion of the taxation of income from lawsuits, see Parker Tax ¶74,130. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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