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Article: Defense Costs Coverage 101

January 16, 2019

A recent New York Law Journal article by Howard B. Epstein and Theodore A. Keyes, “Defense Costs Coverage 101,” reports on defense fees and costs in the insurance coverage practice area.  This article was posted with permission.  The article reads:

Upon receipt of a claim, the risk manager or in-house counsel should coordinate with the company’s insurance broker to make sure notice is submitted to the insurer. However, even earlier, in anticipation of claims, counsel should review the terms of the relevant insurance policies and develop an understanding of the defense cost coverage provisions.

An insurance company’s obligation to pay defense costs incurred by its insured in response to a claim typically falls into one of two categories: (1) a duty to defend or (2) a duty to advance defense costs. The duty to defend is most often included in general liability (GL) policies while the duty to advance is more likely to be included in directors’ and officers’ liability (D&O) policies. Policy forms can vary, however, and a GL or D&O policy may contain either type of defense obligation. In addition, specialty insurance policies covering, for example, employment practices or pollution liability risks may contain either a duty to a defend or duty to advance clause.

Regardless of the type of insurance policy, an insurer may be willing to consider including either defense clause if requested by the broker or the insured. While each of these clauses provides insurance for defense costs incurred by the insured, there are distinctions worth considering which may dictate which clause is preferable for a given insured.

Duty to Defend

While case law varies to some degree from state to state, the duty to defend is broader than the duty to advance under New York law and the law of the majority of other jurisdictions. It is also well-settled that the duty to defend is broader than the insurer’s duty to indemnify for loss under a policy. The duty to defend is triggered “whenever the allegations in a complaint against the insured fall within the scope of risks undertaken by the insurer, regardless of how false or groundless those allegations may be.” Seaboard Surety Company v. Gillette Company, 64 N.Y.2d 304, 486 N.Y.S.2d 873 (1984). Even where some asserted claims fall outside the scope of covered risks, as long as some of the claims are within the scope of coverage, the insurer will have a duty to defend. Once triggered, the insurer is required to pay defense costs on behalf of the insured.

While the duty to defend is broader than the duty to advance, it also gives the insurer control over the defense of the claim. Typically, where a policy contains a duty to defend, the insurer will have the right to appoint defense counsel. Thus, with a duty to defend policy, the insured gets the benefit of broad defense coverage but gives up the right to choose defense counsel and, effectively, control of the defense.

An exception to this rule, in most jurisdictions including New York, is that where there is a conflict of interest between the insured and the insurer, the insured is entitled to select independent defense counsel. Public Service Mut. Ins. Co. v. Goldfarb, 53 N.Y.2d 392, 442 N.Y.S.2d 422 (1981). In the case of such a conflict, the insurer is responsible to pay the reasonable defense fees of independent counsel.

Duty to Advance Defense Costs 

In contrast to the duty to defend, the duty to advance merely requires the insurer to reimburse the insured for costs incurred in defense of claims. Moreover, while the duty to defend requires the insurer to pay defense costs on behalf of an insured whenever the claims alleged fall within the scope of the risk insured, the duty to advance only requires the insurer to advance defense costs for covered claims.

Policies that contain a duty to advance clause generally require the insurer to advance defense costs on an unspecified “timely basis” or within a specified period of time that can range from 30 to 120 days after submission of invoices. Such policies also typically permit the insurer to allocate defense costs to covered and uncovered claims and thus, in some cases, provide a basis for the insurer to advance only a percentage of the defense costs. In addition, a duty to advance is conditional—in the event that it is subsequently determined that there is no coverage for the claims, the insurer may have a right to seek recoupment of the defense costs from the insured.

On the other hand, in the context of a duty to advance, the insured is typically entitled to select its own defense counsel and has control of the defense as well as the responsibility to defend the claim. In addition, a duty to advance will typically be triggered by a written demand seeking monetary relief whereas a duty to defend, in some policies, will only be triggered by an actual suit.

Key Considerations

Whether a duty to defend or duty to advance is a better fit for a particular insured may depend on several factors including the insured’s profile and the types of potential claims. For example, a cost-conscious insured may prefer a duty to defend because defense costs will be paid directly by the insurer and because the insurer is more likely to pay 100 percent (or close to 100 percent) of the defense costs above the applicable deductible or retention. In contrast, under a policy with a duty to advance, there is likely to be considerable lag time between the submission of legal invoices and payment by the insurer, and there is also a stronger possibility that the insurer will pay less than 100 percent of the invoices—either based on an allocation between covered and uncovered claims or persons or based on the insurer’s defense counsel guidelines.

Where choice of counsel is important to the insured, a duty to advance will likely be the preferred option. Choice of counsel may be of primary importance to an insured if the insured has a relationship with counsel in whom they have developed confidence. Similarly, if the claims at issue require a particular expertise or in-depth understanding of a specific industry, the insured may believe it is better positioned to select counsel than the insurer. Likewise, where the claims asserted threaten the continued viability of the insured’s business, the insured will likely prefer to retain counsel with whom they have substantial experience or counsel with a reputation for expertise in the relevant area.

While a duty to advance clause typically grants the insured the right to select counsel, in some cases selection of counsel will be subject to insurer approval, such approval not to be unreasonably withheld. In the case of either a duty to defend or advancement policy, it may also be possible to negotiate pre-approval of defense counsel.

Where control of the defense is the primary concern, a duty to advance policy will likely be a better fit for the insured. Control may be the primary concern where the insured is involved in a regulated industry and where it may be the subject of investigations or claims by government agencies. Similarly, where the insured operates in an industry in which litigation is relatively common or routine, the insured may prefer to have control over its defense. Likewise, where a claim concerns private, confidential or even potentially embarrassing issues, the insured will likely prefer to have control of the defense.

Timely Notice and Tender

In any event, regardless of the type of defense obligation, the risk manager or in-house counsel should be sure to give timely notice of claim in order to avoid jeopardizing the right to coverage. In addition, it is crucial to give notice as soon as possible because an insurer’s obligation to pay defense costs is not typically triggered until notice has been submitted. So while a couple of weeks’ delay in providing notice may not jeopardize coverage, the defense costs incurred prior to the notice will not be recoverable from the insurer. Further, to the extent that an opportunity for early settlement negotiations may arise, it will be necessary to coordinate those discussions with the insurer. Consequently, notice should always be provided before any significant defense costs are incurred.

Howard B. Epstein is a partner at Schulte Roth & Zabel, and Theodore A. Keyes is special counsel at the firm.

Article: Attorney Fee Collection Suits Bring Mixed Results

December 4, 2018

A recent New York Law Journal article by Christine Simmons, “Collection Lawsuits Bring Mixed Results in Law Firms; Quest for Fees,” reports on attorney fee collection lawsuits by law firms.  The article reads:

It’s the time of year when may law firm managers are fretting about collections—and maybe even thinking of taking clients to court over unpaid bills.  But while suing ex-clients to recover legal fees has become increasingly common, recent court decisions show that such lawsuits can be a gamble.

Take two recent cases, one brought by Arent Fox and another by Windels Marx Lane & Mittendorf.  In the Windels Marx case, a Manhattan judge wound up sanctioning the firm for its lawsuit—potentially a substantial penalty—prompting Windels Marx to file a notice of appeal.  Arent Fox, meanwhile, saw its breach of conflict claims dismissed against two of three defendants it targeted in a breach of contract suit over fees.  While law firms often do obtain judgments against former clients in collection suits, the rulings show that success is hardly guaranteed, even when the firms are sophisticated business litigators.

Windels Marx was seeking $380,833 in unpaid legal fees in its collection suit against several entities in Manhattan Supreme Court.  The midsize law firm in New York had defended a housing entity and a former officer in a civil lawsuit over control of several housing development fund corporations.  Those funds own and manage residential real estate in West Harlem that is rented out to low-income tenants, according to court papers.  Windels Marx, in court papers, said it was also retained to advise in multiple government investigations.

Windels Marx withdrew from the civil case and then sued its former client and the related housing development funds that it was adverse to in the underlying case, seeking unpaid fees.  Ultimately, Manhattan Supreme Court Justice Gerald Lebovits granted summary judgment to the four housing development fund entities sued by Windels Marx.

Knocking out the breach of contract claim against the four funds, the judge took issue with the fact that the officer who signed the firm’s retainer agreement, Joednee Copeland, was not authorized to retain the firm on behalf of the funds.  Copeland was previously president of the entity, formerly represented by Windels Marx, that had sought to control the four housing development funds.

The firm’s “billing records show that, at the time that plaintiff drafted the agreement, it knew that Copeland had been terminated from her position,” said Lebovits, in decision posted Nov. 7.  In denying Windels Marx’s other claims against the four housing development funds, Lebovits said the law firm’s invoices showed work adverse to the interests of the housing development funds.

Lebovits granted only a default judgment of $380,833 for Windels Max against the entity that retained the firm and did not respond to the suit.  It’s not clear whether that entity is still active or has assets to cover the judgment.  Copeland, the president of the entity who signed the firm’s retainer agreement, has been criminally charged in Manhattan Supreme Court under felony counts, according to court records.

In allowing the housing development funds to pursue fees against Windels Marx, the judge said the funds’ “request for sanctions, in the form of payment of their attorney fees, incurred in defending this action … is amply justified, not merely by the lack of merit in [Windel Marx’s] complaint, but by [the law firm’s] attempt to collect attorney fees for work directly adverse to defendants’ interests.”  The judge referred the decision on the amount of fees to a special referee.

William Fried, a Herrick Feinstein partner who represented the housing development funds pro bono, said his firm spent between $50,000 and $100,000 on the case.  “We’re going to be seeking every dime that we spent,” he said.  “We’re pleased with the judge’s decision. We thought the lawsuit never had any merit from day one,” Fried said.  Windels Marx filed a notice of appeal Thursday, stating in court documents that attorneys’ fees were not warranted because Herrick Feinstein worked on a pro bono basis.

In the Arent Fox matter, the law firm saw a mixed result in a recent court ruling, holding on to some claims against an ex-client.  The firm sued three car dealership entities, JDN AA, LLC; Subaru 46 LLC; and DCN Automotive LLC, seeking $278,128 in legal fees.  The firm had represented JDN AA in a lawsuit against Volkswagen Group of America, Inc. challenging the attempted termination of JDN AA’s Audi dealership, according to court documents.

The ex-clients sought to dismiss Arent Fox’s claim for breach of contract, claiming the firm did not allege there was an executed retainer agreement between the parties.  They argued that the March 2014 “engagement agreement” was with only one of the defendants, JDN AA, and was not signed, and that a 2015 “conflict waiver” letter did not involve all defendants and related to one specific engagement.

In a decision last month, Manhattan Supreme Court Justice Joel M. Cohen knocked out a breach of contract claim against two of the three defendants. Cohen said two defendants, Subaru 46 LLC and DCN Automotive LLC, are not referenced by name in any of the engagement documents submitted by Arent Fox.  Nor did Arent Fox submit any evidence that describes the terms of any alleged contract between Arent Fox and either of those entities, the judge said.  Cohen, in his November decision, called the firm’s allegations against the two entities “conclusory.”

Article: Challenge Calif. Insurer Limits on Independent Counsel Rates

November 12, 2018

A recent Law 360 article by Susan P. White, “Challenge Calif. Insurer Limits on Independent Counsel Rates,” reports on hourly rates and independent counsel in insurance coverage litigation in California.  Susan P. White is a partner at Manatt Phelps & Phillips LLP in Los Angeles.  This article was posted with permission.  The article reads:

When a liability insurer agrees to defend its insured after the insured has been sued, this is often cause for celebration, as the insured believes its defense will be paid.  The insurer may reserve its rights to deny coverage, and advise that such reservation creates a “conflict of interest” entitling the insured to “independent” counsel.  Thus, instead of the insurer selecting the insured’s defense counsel, which is common under a duty to defend policy, the insured gets to choose its own counsel.  Still reason to celebrate, right?  But, as you may suspect, this selection right comes with a catch.  The insurer advises that while the insured can choose its own counsel, the insurer only agrees to pay a very low hourly rate, maybe $225 or $250 per hour (it varies, sometimes dramatically so), which is much less than what is being charged by the insured’s independent counsel.  If the litigation against the insured is significant, the delta between the rate the insurer agrees to pay and counsel’s actual rate can add up to millions of dollars.

An insurer claims it need only pay these low hourly rates pursuant to the requirements set forth in California Civil Code section 2860(c), which governs the financial relationship between an insurer and an insured’s independent counsel. Section 2860(c) states:

The insurer’s obligation to pay fees to the independent counsel selected by the insured is limited to the rates which are actually paid by the insurer to attorneys retained by it in the ordinary course of business in the defense of similar actions in the community where the claim arose or is being defended.

While section 2860(c) allows an insurer to only pay independent counsel the same rates it pays to other lawyers to defend similar actions in the same locale, an insured should not simply accept the insurer’s say so on this.  There are several ways to both challenge an insurer’s unilaterally imposed rates.  This article addresses a few such ways.

First, an insured should demand that the insurer produce detailed information about the counsel to whom it is paying these low rates.  An insurer often imposes “panel counsel rates” in these situations, which are rates that an insurer pays to certain law firms that have special agreements with the insurer, often in writing.  In these agreements, the panel counsel often agree to charge the insurer reduced hourly rates, regardless of the type of case, or location of the litigation, typically in exchange for the anticipation of a large volume of work from the insurer.  Under such a situation, an insured can argue that there is no “similarity” of actions as mandated by the statute.  Instead, the panel counsel’s rates are unaffected by the complexity, sophistication, nature of the allegations, legal claims, factual circumstances, location or any other factors of the cases in which they are appointed.  Thus, such rates provide no support under the § 2860 requirements.

Second, an insured should demand that the insurer provide detailed information about the specific cases that the insurer is touting as “similar actions in the community where the claim arose or is being defended,” to support the low hourly rates imposed.  With this information, an insured can ascertain whether such cases are, in fact, “similar” or not.  For example, are these purported “similar” actions less complex than the lawsuit against the insured? Do they involve different legal and/or factual issues?  What about the amounts in controversy — are they dramatically less and thus, the exposure potentials are not even comparable?  Also, where are these other actions pending?  Are they in different communities?  The more an insured can demonstrate dissimilarities the better to demonstrate that the insurer cannot support the hourly rate it seeks to impose pursuant to § 2860.

Third, if the parties cannot informally agree on an acceptable hourly rate for independent counsel, either party can seek to resolve the dispute through final and binding arbitration pursuant to § 2860.  And, in any arbitration, if the arbitrator determines that insurer’s evidence does not satisfy the § 2860 requirements, the insured should argue that a “reasonableness” standard should be applied to determine the appropriate rate for the insured’s independent counsel (with evidence to support that independent counsel’s actual rates are “reasonable”).  Indeed, a “reasonableness” standard is a ubiquitous standard for attorneys’ fees in insurance litigation and other contexts.

An insured need not simply accept its insurer’s word when it imposes inappropriately low hourly rates on an insured’s independent counsel.  Instead, an insured should challenge such rates, when appropriate, either informally or in arbitration.

Susan P. White is a partner at Manatt Phelps & Phillips LLP in Los Angeles.  Susan resolves complex insurance coverage disputes through litigation, arbitration and mediation.  These include bad faith claims, as well as other commercial and contract matters.  She has also successfully recovered millions in attorneys’ fees and costs for her insured clients.

Article: Deal with Billing Issues Mid-Year to Avoid Year-End Rush

August 29, 2018

A recent Daily Report article by Shari L. Klevens and Alanna Clair, “Yes, It’s Still Only August, But You Can Avoid the Year-End Rush on Billing Issues, reports on the fundamentals of effective fee collections.  This article was posted with permission.  The article reads:

Issuing bills and collecting fees can be a challenging task for many attorneys.  Some find it difficult to give billing issues the attention they need, given the demands of their law practice.  Often, attorneys may feel tempted to ignore billing issues until the year-end collections push.  However, by only focusing on billing at one time during the year, attorneys (and firms) may end up leaving earned fees on the table or could otherwise miss red flags that could indicate other problems with the representation.

Thus, many firms will encourage their attorneys to take a serious look at outstanding invoices, work in progress fees and overdue accounts prior to the year-end push.  Although December may be the appropriate time for the final push, summer can be the time to reinforce the fundamentals for effective fee collections.

Are Bills Being Paid?

Assuming that bills are sent regularly, if a client is not paying its invoices regularly or in full, this time of year can be a helpful time to investigate.  Waiting until December may leave the firm with fewer options and little time to deal with unpaid bills.  Clients have many options for how and when they pay bills.  Some clients review amounts or even appeal the invoices before paying.  Others may regularly let bills accumulate and pay them in full quarterly.  However, the failure of a client to pay over an extended period of time can indicate a problem, either with the client’s ability to pay, or, in some circumstances, with the relationship.

If bills are remaining unpaid, many attorneys will investigate to try to identify the source of the delay.  For example, the bills might have been sent to the wrong person or, it could be that the firm or the invoices are not in the client’s system.  On the other hand, it could be that a client is receiving the bills, but nonetheless is refusing to pay some or all of them.  When this happens, there are several potential explanations.

Some clients refuse to pay because they dispute the amount of the bill.  In such a circumstance, the attorney may choose to engage in some frank discussions regarding the work performed and anticipated future work and billings.  Getting everyone on the same page about both the amount of work a matter requires and the cost of that work is important to avoid even bigger disputes down the road.  The attorney may choose to discount or write-off amounts—as a client service issue—if the amounts exceed what was expected.

However, if the client is refusing to pay because the client is dissatisfied with the quality of work, then additional steps may be helpful.  Typically, ignoring such dissatisfaction does not make the issue go away and can get worse with time.  Most firms in this situation will confront the issues directly to determine whether the client is unfairly refusing to pay or if there is a more serious quality issue.

Most often, fee disputes reflect misunderstanding about what work the attorneys are doing and what costs are associated with that work.  If a client does not understand a bill or thinks they are being overcharged, it might be because the bill does not provide enough detail or because it is hard to read.  The solution could be as simple as revising billing entries so they provide more information.  Unfortunately, sometimes nonpayment means the client simply does not have the financial resources to pay.  It is always better to find that out sooner rather than later.

Are Bills Being Sent?

In taking inventory of accounts receivable and work in progress fees, law practices can also review whether their invoices are being sent on a regular basis.  Whether fees are being paid can be directly impacted by whether attorneys are getting their bills out with regularity.

Failing to send bills regularly can have direct and practical impact on the attorney-client relationship.  If bills are not sent regularly, sending an invoice that encompasses several months of work can come as an unpleasant surprise to a client.  A client may even begin to question the work that has already been completed if irregular bills suggest that the representation is unusually expensive.  Typically, an effective way to avoid that surprise is to ensure invoicing is timely.  Monthly, digestible bills reduce the risk of a fee dispute and increase the chances of prompt payment.  Regular invoices also help educate and confirm for clients what tasks are being completed in the matter.

In addition to ensuring good client relations, regular bills avoid the risk that the firm or practice has a substantial amount of fees invested before learning that it has a client problem or an objection to payment.  With frequent, regular bills, nonpayment or fee disputes typically involve a much smaller amount than disputes resulting from a single bill covering six months or a year of legal fees and expenses.  Issuing bills in regular (and therefore smaller) amounts reduce the risk of a dramatic hit to the bottom line if there is a dispute.

With all that said, one of the most important reasons for monthly or regular billing is to address one of the most common reasons why clients do not pay: they never received an invoice.  Systematic billing in regular intervals ensures that crucial step for getting paid by ensuring that bills are sent.

Billing is one way of informing the client of the work being done and the time being spent on their case.  By assessing billing issues at mid-year, attorneys can reduce the stress of the year-end collections crunch.

Article by Shari Klevens and Alanna Clair of Dentons US LLP, reprinted with permission of ALM Media Properties, LLC.  Shari L. Klevens is a partner at Dentons US in Atlanta and Washington and serves on the firm’s U.S. board of directors.  She represents and advises lawyers and insurers on complex claims and is co-chair of Dentons’ global insurance sector team.

Alanna Clair is a partner at Dentons US in Washington and focuses on professional liability and insurance defense.  Shari and Alanna are co-authors of “The Lawyer’s Handbook: Ethics Compliance and Claim Avoidance” and the upcoming 2019 edition of “Georgia Legal Malpractice Law.”

Taxation of Attorney Fee Awards in Legal Malpractice Cases

July 24, 2018

A recent New Jersey Law Journal article by Paul J. Maselli, “Taxation of Attorney Fee Awards in Legal Malpractice Cases,” reports on the taxation of attorney fee awards in legal malpractice cases.  This article was posted with permission.  The article reads:

The recent tax law changes may impact and increase damage awards in legal malpractice cases.  In New Jersey, when a former client successfully sues a former attorney for legal malpractice, the client is entitled to recover the fees incurred for the malpractice lawsuit as part of the measure of damages.  New Jersey’s Supreme Court established this fee-shifting rule, which is an exception to the American Rule that provides each party pays their own attorney fees for a lawsuit, in the 1996 case Saffer v. Willoughby, 143 N.J. 256 (1996).  The court stated that attorney fees in a legal malpractice case are consequential damages and available “to put a plaintiff in as good a position as he [or she] would have been had the [attorney] kept his [or her] contract.” Id. at 271.

Under the tax laws that expired at the end of 2017, an individual’s attorney fees (whether incurred or reimbursed) were either fully excluded from income or deductible as a miscellaneous expense to the extent the attorney fees exceeded 2 percent of the individual’s adjusted gross income, and the individual was not subject to the Alternative Minimum Tax.  The Tax Cuts and Jobs Act of 2017 eliminated miscellaneous expenses as a deduction from adjusted gross income, which means that attorney fee awards are now taxable in a whole category of situations not previously taxed.

If the underlying claim is for recovery of money that will be taxed (such as a claim for unpaid wages or lost profits), the award of attorney fees is not taxed.  26 U.S.C.A. §212(1). Where the claim is for non-taxable damages, the award of attorney fees is taxed.  This means that, with some exceptions, a plaintiff awarded attorney fees pursuant to a statute, case or court rule must treat the recovery as income subject to taxation by the Internal Revenue Service and State of New Jersey, including the legal fees paid to plaintiffs in legal malpractice cases where the compensatory damages are not taxable.

As for exceptions, the compensatory damages in personal injury or sickness cases are not taxable whether the funds are retained by the client or paid to the attorney. 26 U.S.C.A. §104(a).  Awards for damages and attorney fees in discrimination suits and whistleblower claims are not included in adjusted gross income and thus not taxable.  26 U.S.C.A. §62(a)(20) and (21).  But awards of attorney fees to individuals are now taxable in all other cases not related to the collection of taxable money.

Attorney fee awards in legal malpractice cases handled on a contingency fee basis are not subject to the time spent/hourly rate lodestar, instead, courts may award the one-third contingency fee if that is the arrangement between malpractice lawyer and client.  Distefano v. Greenstone, 357 N.J. Super. 352, 361 (App. Div. 2003).  Awards can be quite high.

Whether the compensatory damages awarded in a legal malpractice case are taxable depends on the nature of the underlying claim.  United States v. Gilmore, 372 U.S. 39, 49 (1963).  If the plaintiff sues her attorney for professional negligence in her representation in a claim for an inheritance, the compensatory damages recovered in the malpractice case are not taxable because there is no federal or state inheritance tax.  If the plaintiff sues the attorney for malpractice in handling a case for the recovery of unpaid wages, on the other hand, the compensatory damages are taxable because the unpaid wages would have been taxed.  26 U.S.C.A. §104(a)(1)(a).  Finally, if the attorney’s negligence occurred in a claim to recover the client’s security deposit, the compensatory damages would not be taxed since there is no tax on the recovery of a party’s capital.  Clark v. Commissioner, 40 B.T.A. 333 (1939), acq., 1957-1 C.B. 4 and Rev. Rul. 57-47, 1957-1 C.B. 23.

In the inheritance and security deposit case, the attorney fee awards are taxed because they do not fall within an exception and the claim for compensatory damages is not taxable income.  If the measure of damages is to place the plaintiff “in as good a position” as he or she would have enjoyed had the attorney not malpracticed, then the plaintiff’s obligation to treat the attorney fee award as income and pay taxes on it certainly detracts from the plaintiff being in as a good a position.

Plaintiffs now will be seeking an augmentation of any attorney fee award to recoup an amount sufficient to pay the taxes. Known as a “tax gross up,” this concept is not new.  In Oddi v. Ayco Corporation, 947 F.2d 257 (7th Cir. 1992), the court considered a negligent tax planning and advice claim in which the tax advisor made an error calculating the tax impact of a transaction for his investor client.  The court awarded damages not only for the difference between the advised amount and the actual amount, but augmented the award to include an amount for the income taxes that would be incurred on the award. Id. at 261.  The trial court’s award was not disturbed on appeal.

In Jobe v. International Insurance Company, 933 F.Supp. 844 (D. Ariz. 1995), the court relied on Oddi as it outlined the damages available to a plaintiff in a tax malpractice case:

Damages in a tax malpractice case are the difference between what the plaintiff would have owed if the tax returns had been properly prepared and they owe now because of the professional’s negligence, plus incidental damages.  Thomas v. Cleary, 768 P.2d 1090, 1091–92 n. 5 (Alaska 1989).  The injured plaintiff in a tax malpractice action may recover: (1) the taxes paid after audit, appeal and/or settlement attributable to the negligence; Thomas, 768 P.2d at 1092; (2) interest paid on those taxes; (3) prejudgment interest on taxes and interest paid, Wynn v. Estate of Holmes, 815 P.2d 1231, 1235–36 (Okla. Ct. App.1991); (4) professional fees incurred in defending the audit, Thomas, 768 P.2d at 1092; (5) all fees paid to a lawyer who acts while in a conflict situation, Day v. Rosenthal, 170 Cal. App.3d 1125, 217 Cal.Rptr. 89, 113 (Ct.App.), cert denied, 475 U.S. 1048, 106 S.Ct.1267, 89 L.Ed.2d 576 (1986); and (6) additional taxes a plaintiff will incur on receipt of the damages award. Oddi v. Ayco Corp, 947 F.2d 257 (7th Cir.1991).

Id. at 860 (emphasis added).

While it benefits the clients, the attorneys and the insurance company to pay taxes that the government uses for education, roads and police, most litigants see it differently—not welcoming the opportunity to pay taxes.  One tax-avoidance strategy for settlement negotiations is to attribute all or as much of the settlement amount to compensatory damages that have some justification in fact.  The plaintiff may be asserting $100,000 in compensatory damages but may have proof problems with $30,000 of that amount which results in the plaintiff accepting an $80,000 settlement offer.  Instead of itemizing the settlement as $70,000 for compensatory damages and $10,000 for taxable attorney fees, the parties can agree to settle for $80,000 in compensatory damages with the plaintiff waiving the claim for attorney fees.  The settlement number is still less than the maximum compensatory claim and the itemization is justifiable, and no part of the settlement was paid for attorney fees.

This strategy is supported by the finding of the United States Tax Court in Concord Instruments Corp. v. C.I.R., 67 T.C.M. (CCH) 3036 (T.C. 1994) (1994 WL 232364).  There, a taxpayer sued for compensatory damages of $466,000 arising from legal malpractice for its attorney’s failure to file an appeal of a tax assessment.  The $466,000 was comprised of taxes and interest paid from the taxpayer’s capital.  The case settled for $125,000 and the IRS wanted to tax the settlement, asserting that it was income to the taxpayer.  The tax court ruled that $125,000 was paid to settle a claim in which the taxpayer sought a return of capital, and since damages for a return of capital are not taxed, the $125,000 settlement was not taxed.

The court reasoned that the nature of the settlement (whether taxable income or non-taxable return of capital) is determined by looking at the nature of the claim, not the merits of the claim.  “The tax consequences of an award for damages depend on the nature of the litigation and on the origin and character of the claims adjudicated, but not the validity of such claims.” Id.

The IRS argued that the taxpayer would never have won its appeal if the attorney had timely filed the appeal, and since the taxpayer would not have won the appeal, the payment of $125,000 must be considered income to the taxpayer.  The court disagreed.  As the tax gross up issue evolves with the settlement and adjudication of legal malpractice cases in New Jersey, practitioners will likely develop more strategies for the avoidance of the payment of taxes on attorney fee awards. Creative minds are required.

Paul J. Maselli is a shareholder with Maselli Warren in Princeton.