Taxing Terrorism Under the Federal Sovereign Immunities ...

1 WOODCRAFT. (C) Tax Analysts 2016. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. tax notes . Taxing Terrorism Under the priorities, including claims of other creditors. Some of those other claims may be from other families of Federal Sovereign Immunities Act victims of international Terrorism . What is clear is By Robert W. Wood that foreign Sovereign immunity precludes persons from initiating civil proceedings against foreign Robert W. Wood practices Therefore, traditional state law causes of action, law with Wood LLP (http://. ) and is such as wrongful death, are unavailable. If an the author of Taxation of American is killed or injured in an act of Terrorism , Damage Awards and Settle- the case may start with a private Federal cause of ment Payments, Qualified action for damages for death resulting from state- Settlement Funds and Section sponsored Terrorism Under 28 section 468B, and Legal Guide to In- 1605A(c), part of the Foreign Sovereign Immunities dependent Contractor Status, Act of 1976 (FSIA, 94-583).

2 2 But this may be the all available at http://www. first step in a long and arduous process. Robert W. Wood This dis- cussion is not intended as If one leaps ahead years and sees an eventual legal advice. recovery, the question whether the recovery is sub- ject to tax is hardly inconsequential. Some types of In this article, Wood explores the tax treatment of compensation for the victims and their families litigation recoveries receive IRS guidance and case of international Terrorism . law authorities. Yet many types of cases spawn no tax authority, and claims Under the FSIA are in that Copyright 2016 Robert W. Wood. category. All rights reserved. Of course, a fundamental precept of tax law is that recoveries in litigation are taxed according to Fortunately, few Americans should ever need to the origin and nature of the underlying claims.

3 Consider litigation arising out of acts of Terrorism . Compensatory damages for wrongful death or per- Apart from the heartache that prompts that litiga- sonal physical injury should be tax free Under tion, those who undertake it are likely to be in for section 104. If an underlying recovery in litigation long and uncertain roads to any recovery. If they do would be excludable from the plaintiff's income eventually recover, the recovery may appear on the Under section 104, a claim against other parties to surface to be nothing like a typical personal physi- redress those wrongs should be, too. cal injury or wrongful death case. The parties are different, the procedures and The classic example is a claim for legal malprac- courts are different, and the cast of characters is tice. Suppose you are injured in a car crash, but different.

4 Any eventual recovery may involve asset your lawyer fails to file the complaint on time, so forfeitures and bank levies, with a new breed of you cannot recover. If you eventually recover from lawyer at the helm. And the case may involve the the lawyer for his malpractice, your recovery intricacies of foreign and banking and sover- should be tax free. eign Immunities laws. Your recovery would have been tax free had you Typically, to receive compensation, families of collected it from the proper party. As a result, your victims of international Terrorism must obtain judg- malpractice recovery is given the same tax-free ments against foreign state sponsors of Terrorism . character even though it was not the lawyer who They must then identify assets of the foreign injured you in the car crash. The same rationale states that are not blocked or otherwise considered should be applied to Terrorism cases.

5 Diplomatic property. They would then initiate at- tachment and execution proceedings to satisfy the judgments. 1. 28 section 1604. This can be involved and difficult. Often, a case 2. Codified at 28 sections 1602, 1330, 1332, 1391(f), will involve delicate maneuvers and disputes over 1441(d), and 1602-1611. TAX NOTES, April 18, 2016 387. For more Tax Notes content, please visit COMMENTARY / WOODCRAFT. Attachment and Execution physical In 1995 the Supreme Court in Commissioner v. Schleier12 enunciated a two-prong (C) Tax Analysts 2016. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. Under section 1610(c) of the FSIA, attachment or test for excludability. execution is not permitted until the court deter- mines that a reasonable period has elapsed from the First, the taxpayer must show that the underly- entry of a final judgment and notice has been ing cause of action giving rise to recovery is based provided.

6 The plaintiff's recovery is likely to come upon tort or tort type rights.'' Second, the taxpayer about by turnover motions Under section 1610(g) of must establish that the award received was on the FSIA and section 201(a) of the Terrorism Risk account of'' personal injuries or physical Insurance Act of 2002 (TRIA, 107-297). How- But in January 2012 the regulations abandoned the ever, the case generally starts with a private Federal requirement that a recovery be based on a tort or cause of action for damages for death resulting from tort type state-sponsored Terrorism Under section 1605A(c) of the FSIA. The FSIA permits a plaintiff to recover economic 11. Section 104(a)(2). TRIA permits recovery of only compen- damages, solatium,3 and punitive damages, as well satory damages; therefore, punitive damages cannot be recov- as damages for pain and The defendant ered Under TRIA.

7 See section 201(a) of TRIA ( blocked assets of may well fail to file an answer. A district court may that terrorist party (including the blocked assets of any agency or instrumentality of that terrorist party) shall be subject to thereafter move on to a default proceeding as execution or attachment in aid of execution in order to satisfy provided by the Under the FSIA, a court may such judgment to the extent of any compensatory damages for enter a default judgment against a non-responding which such terrorist party has been adjudged liable''). Accord- foreign state only when the claimant establishes ingly, the recovery consists of only compensatory damages . his claim or right to relief by evidence satisfactory pain and suffering, economic damages, and solatium. 12. 515 323, 336 (1995). to the court.

8 '' 13. Id. After the Supreme Court issued its opinion in Schleier, In general, the origin of the claim controls the tax Congress amended section 104(a)(2) by adding the requirement that to be excluded from gross income, any amount received treatment of a litigation The IRS and the must be on account of personal injuries that are physical or courts ask in lieu of what were the damages sickness that is physical. See Small Business Job Protection Act of The determination of the origin of the 1996, 104-188, section 1605. This amendment does not claim is factual and is made by reference to the otherwise change the requirements of section 104(a)(2) or the issues raised in the complaint, issues litigated, and analysis in Schleier. Rather, it imposes an additional requirement for an amount to qualify for exclusion from gross income Under issues resolved in a verdict or section 104(a)(2).

9 See Hansen v. Commissioner, Memo. 2009- 87. On January 23, 2012, the phrase tort or tort type'' rights was The IRS and the courts usually view the com- eliminated from reg. section (c)(1). However, the com- plaint as the most persuasive evidence of the origin ment to that regulation states that the phrase was used to of the Nonetheless, the IRS and the courts distinguish between damages from personal injuries and dam- also look to the other ages from breach of contract cases and that it was eliminated in part because of the phrase on account of'' in the second prong Section 104(a)(2) of Schleier. It appears that the language underlying cause of action giving rise to recovery'' has been undisturbed by the Section 104(a)(2) provides an exclusion for regulatory elimination. Today, reg. section (c)(1) still personal physical injuries or physical sickness.

10 The requires that recovery of damages from physical injuries be exclusion applies to damages, other than punitive related to a suit or be in lieu of a suit. See Perez v. Commissioner, damages, received (whether by suit or agreement) 144 51 (2015). Further, courts have continued to apply the first prong of Schleier after January 23, 2012. See Smallwood v. on account of'' personal physical injuries or United States, No. 12-00023 ( Cal. 2012); Molina v. Commis- sioner, Memo. 2013-226; Harris v. Commissioner, Memo. 2012-333. 14. 9573 (eliminating the phase tort or tort type rights''). 3. Solatium is a form of compensation for emotional rather See reg. section (c)(2), titled Cause of action and rem- than physical or financial harm. edies'' ( The section 104(a)(2) exclusion may apply to damages 4. 28 section 1605A(c).)