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Tax,
Law Practice

Dec. 15, 2020

The taxman cometh for lemon law litigants

A combination of the evolving nature of lemon law litigation in California under the Song-Beverly Warranty Act and changes to the federal tax code that repealed the deduction for certain attorney fees awards can cause adverse tax consequences.

Jay Weill

Partner, Sideman Bancroft LLP

A combination of the evolving nature of lemon law litigation in California under the Song-Beverly Warranty Act, Civil Code Sections 1790 et seq., and changes to the federal tax code that repealed the deduction for certain attorney fees awards can cause adverse tax consequences. The act's fee-shifting provisions -- which often force automobile manufacturers into settling cases on, even purportedly questionable claims -- effectively limit the number of cases that actually go to trial.

Manufacturers who pay civil penalties and attorney fees under the act must report those payments to the Internal Revenue Service. Internal Revenue Code Sections 6041 and 6045. Certain payments to third parties require manufacturers to file and issue Forms 1099, which reflect the amounts of these payments and identifying information of the payees. To determine whether manufacturers must issue Forms 1099, first you need to determine whether the underlying amounts paid are taxable to the plaintiff litigants. The short answer is yes. The law makes clear that civil penalties and attorney fees paid under the act are taxable income to plaintiff in all circumstances -- i.e., whether or not monetary penalties and attorney fees are paid pursuant to a judgment after trial or the settlement of a claim. See Comm'r v. Banks, 543 U.S. 426 (2005); Comm'r v. Glenshaw Glass Co., 348 U.S. 426 (1955); Sinyard v. Comm'r, 268 F. 3d 756 (9th Cir. 2001); IRC Sections 104, 3406, 6041, 6045, 6721 and 6722; and Treasury Regulations Sections 1.6041-1 and 1.6045-5.

Any award or settlement for an amount in excess of the returned purchase price of a vehicle is taxable income to the plaintiff in a case under the act, and therefore must be reported by a manufacturer on a Form 1099 filed with the IRS and mailed to the plaintiff. The failure to file required Forms 1099 can expose manufacturers to significant penalties under IRC Sections 6721 and 6722, which provide for penalties of up to 10% of the amounts that should have been reported. So the taxman will cometh even if the plaintiff litigant fails to report as income the taxable portion of the recovery.

Damages can be greater than the cost of a vehicle repurchase, which are nontaxable. However, civil penalties that can be awarded under the act are not exempt from federal or state income taxes. While the act shifts attorney fees for the plaintiff's pursuit of civil penalties to the manufacturers, the IRC imposes tax liability for those fees even though they might pass from the attorney to the client. For example, an award of $50,000 for the repurchase of a vehicle and a $100,000 penalty award, accompanied by a $200,000 attorney fees award, converts a $50,000 tax-free vehicle repurchase into a complicated income tax event. The plaintiff must pay income taxes on the $100,000 civil penalty as well as on the amount of attorney fees involved in the recovery. With such an award, the plaintiff will likely be pushed into a higher tax bracket. For example, under the above hypothetical, let's assume a tax rate of 30% to demonstrate the tax consequences to the plaintiff of the resolution a case whether by settlement or judgment:

Components of the recovery

• $50,000 awarded as the cost of repurchase of the vehicle (nontaxable).

• $100,000 civil penalty award ($30,000 tax liability to plaintiff).

• Assume a 45% contingency fee to counsel ($55,000 to the plaintiff, $45,000 to the attorney).

• $200,000 attorney fees award ($60,000 tax liability to plaintiff).

Bottom line: After accounting for federal income taxes owed and counsel's contingent fee, the plaintiff will net only $15,000.

The takeaway: Plaintiffs' counsel and their clients who bring lemon law cases under the Song-Beverly Warranty Act need to recognize that the penalty and attorney fees claims are not "free money." Such awards can cause considerable tax consequences to their clients and can diminish or eliminate any financial benefit to the client. 

#360753


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