Sunday, March 1, 2015

The Peril of Settling a Lawsuit Without Addressing Tax Consequences

The Peril of Settling a Lawsuit Without Addressing Tax Consequences


            McClusky sued his lender over a foreclosure, asserting that the bank had failed to mitigate its damages.  In settlement of that dispute, McClursky paid a nominal amount to the bank and it agreed to release and negate the balance of its deficiency judgment.  The settlement agreement was silent as to the tax treatment of that release.  When the bank issued to McClusky a Form 1099 reporting the amount forgiven as cancelation of indebtedness he objected.  That objection was found to be without merit.  McClusky v. Century Bank, FSB, ___ Fed. Appx. ___, 2015 WL 327596 (6th Cir. Jan. 26, 2015).

            McClursky, after incurring a tax liability of $68,660 on the $159,478.87 of discharged debt, asserted that Century had breached the settlement agreement by issuing the Form 1099.  The trial court would agree with McClursky, applying the “contested liability doctrine” to the effect that there was no debt released that could generate reportable income.  The Court of Appeals would reject that reasoning and return to the language of the settlement agreement.

            Cutting to the chase, the 6th Circuit found:

A straightforward application of Ohio contract law to the Settlement Order – which the parties agree is a valid contract – confirms that the order did not prohibit Century Bank from filing the McClusky 1099.  2015 WL 327596, *3.

            Focusing on the terms of the two paragraph Settlement Order, the Court wrote:

McClusky nonetheless insists, and the district court held, that Century Bank breached the Settlement Order by issuing the McClusky 1099. We disagree. The Settlement Order says nothing about how each party would treat the transaction memorialized in the Settlement Order for tax purposes nor about how (or whether) each party would report the transaction to the IRS. Given the complete absence of any reference to tax reporting issues, the Settlement Order cannot be read as precluding Century Bank from issuing the McClusky 1099. Indeed, it would violate Ohio’s fundamental rules of contract interpretation to read into the Settlement Order a limitation on Century Bank’s conduct that the order simply does not contain.  2015 WL 327596, *4.

The Court noted that it is common in agreements of this nature to specify the tax consequences of the transaction, citing several secondary sources in support thereof.

            In that Century Bank, in issuing the Form 1099, did not violate the Settlement Order, McClusky’s breach of contract action was dismissed.

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