Reasonable people, including those within the IRS bureaucracy, will disagree on what constitutes an “ordinary and necessary” business expense – a big area of tax deductions.
Another area concerns whether litigation proceeds to compensate for damages to farm or ranch property constitute taxable income. There are many lawsuits brought by owners of ranches, horse farms and agricultural farms against chemical companies and others for environmental torts. These cases often pertain to damages caused to land, leasehold, crops, livestock, other inventory or other interests that result in diminished profits and loss of goodwill. Sometimes the claim also includes personal injuries to the health and well-being of the owner and family, including health problems such as chronic respiratory illnesses.
Sometimes cases have been brought against companies for product liability, such as for fungicides that may have been unsafe and resulted in damages to property. Other cases in which large settlements have been received have involved environmental damage that severely impacted on the ability to conduct business.
When a judgment or settlement is made in connection with civil litigation, the amount may be significant so as to compensate the plaintiff for business interruption and other damages. The question arises, how are such proceeds to be treated for income tax purposes? Often accountants will advise farmers and ranchers that such proceeds must be reported as ordinary income because they are treated as proceeds for loss of profits.
Sometimes plaintiffs also receive proceeds from use and occupancy insurance, which is intended to compensate for business interruption, and this further complicates the picture. In tax opinion letters I have generated, I have found that in many instances people have overpaid on taxes with respect to settlement proceeds, and in some instances they are entitled to completely exclude the proceeds from income tax.
Proceeds from damages to farmers and ranchers can, in many situations, be allocated as a return of capital with respect to intangible assets such as goodwill, franchises, trademarks or other assets that represent valuable legal rights in a business. Also, damages for loss of inventory by reason of the acts of the defendants can be characterized as capital rather than profits. This can result in substantial tax savings. Generally speaking, if damages are properly allocated as compensation for injury to goodwill or other intangible assets, such recoveries may be tax-free.
Goodwill is unique because unlike receivables, inventories and patents that can be sold or exchanged individually in the marketplace, goodwill can be identified only with the business as a whole.
In order for settlement proceeds or a judgment from a civil lawsuit to be excluded from tax, it is important to structure the settlement agreement to clearly indicate how the funds are being allocated – whether they are to compensate for loss of goodwill, property damage and/or personal injuries, and if so, the nature of the injuries.
But clearly if a settlement is to compensate the plaintiff for property damage and for loss of goodwill, the proceeds in general are excluded from income tax. Goodwill is an extremely important element in any viable business.
John Alan Cohan is a lawyer who has served the farming, horse and livestock industries since 1981.
