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Consumer Class Actions: 14.8.3.1 Generally

This section will discuss tax considerations in settling class actions. While it cannot replace a consultation with a knowledgeable tax advisor, it will raise several issues to be considered concerning the tax implications of a class action settlement or award.70 These considerations may help shape the exact structure of the engagement and settlement to ensure that the class receives an adequate award after tax considerations are taken into account.

Consumer Class Actions: 14.8.3.3 Allocation Between Taxable and Non-Taxable Portions

Occasionally a settlement agreement will allocate the recovery to non-taxable and taxable portions. If this allocation is challenged, the Internal Revenue Service (IRS) and courts will consider all facts—including the allegations contained in the complaint, the evidence presented, the arguments made in the court proceeding, and the intent of the payor to determine the proper allocation.81

Consumer Class Actions: 14.8.3.4.1 Reimbursement for overcharges

Consumer cases often focus on damages resulting from breach of warranty, deception, or breach of contract: the consumer paid an amount for goods or services or related charges and did not receive in full what the consumer should have received. Consider a consumer who pays $10,000 for a car, but the seller delivers a rebuilt wreck worth only $6000 or fails to perform $4000 worth of promised repairs.

Consumer Class Actions: 14.8.3.4.2 Statutory, minimum, and multiple damages

In general, statutory, minimum, and multiple damages are taxable. There may be an exception if they can be viewed under state law as a proxy for non-taxable compensatory damages. Sometimes state law treats them as a proxy for a compensatory award that is difficult to prove when public policy requires the consumer to be fully compensated despite such problems of proof. Also consider the situation in which the statute awards minimum or actual damages, whichever is greater.

Consumer Class Actions: 14.8.3.4.3 Damages emanating from physical injury

Although physical injury damages are rarely obtained in consumer class actions, it should be noted that gross income does not include damages (other than punitive damages) in a suit or settlement on account of personal physical injuries or physical sickness.87 In order to exclude these damages from gross income, a taxpayer must demonstrate that the underlying cause of action giving rise to the recovery was based on tort or tort-type rights.88 State law decides whether a tort-type injury is i

Consumer Class Actions: 14.8.3.5.1 The general rule

Debt that is canceled, forgiven, or discharged—often referred to as COD (cancellation of debt) or DOI (discharge of indebtedness)—is generally treated as taxable income unless the debt was disputed.95 When the taxpayer obtained the loan or agreed to pay on credit, the taxpayer did not have any income because the taxpayer did not have “accession to wealth” due to the corresponding obligation to repay the lender. If the debt is cancelled, the taxpayer has taxable income at the time of the cancellation.

Consumer Class Actions: 14.8.3.5.2 Exception for bankruptcy

The Internal Revenue Code specifically excludes from gross income any COD income resulting from the cancellation of consumer debt in a bankruptcy case.100 The timing is crucial. If the debt is discharged as a result of the bankruptcy, the COD is entirely excludable from gross income.101 The bankruptcy exception does not apply if the debt is forgiven before the bankruptcy action or after it has concluded.

Consumer Class Actions: 14.8.3.5.3 Exception for insolvency

The Internal Revenue Code specifically excludes from gross income any debt cancellation made while the debtor was insolvent102 to the extent of the insolvency. Consider, for example, a taxpayer with assets valued at $18,000 and liabilities of $26,000. This taxpayer is insolvent by $8000. If $12,000 of the debt is forgiven, the debtor has $12,000 worth of COD income. Eight thousand dollars of the COD income would be excludable but not the other $4000 (because the taxpayer is no longer insolvent once the first $8000 has been forgiven).

Consumer Class Actions: 14.8.4 Class Settlement Fund Versus Fixed Individual Recoveries

Class settlements can be structured differently, depending on the facts of the case and the needs of the class and the defendant. One key choice is whether to set a fixed total amount the defendant will pay or to set a fixed payment amount per class member, in which case the defendant’s total payment may vary depending on how many class members file claims if they are required.

Consumer Class Actions: 14.8.5 Prohibition on Geographic Discrimination

Under the Class Action Fairness Act of 2005, for class actions filed after 2005,123 federal courts cannot approve settlements that result in greater payments to class members living in geographic proximity to the court.124 This prohibition is strange because it is not clear what abuse it is attempting to stop. It also is unclear what practical import this prohibition will have in actual cases.

Consumer Class Actions: 14.8.7 The Named Plaintiff’s Individual Recovery

The settlement agreement should include a term covering any individual recovery for the plaintiff in addition to the plaintiff’s share of the class recovery. Sometimes such a payment may be appropriate if the named plaintiff had additional non-class claims that also are being settled or if the named plaintiff is providing a general release, whereas class members will only release the claims in the complaint.

Consumer Class Actions: 14.8.9 Reimbursement of the Class’s Expenses

As part of the settlement, the plaintiff’s litigation costs and expenses should be reimbursed, including expert fees, deposition costs, travel expenses, and the like. Generally, these are not strictly limited to costs taxable under 28 U.S.C. § 1920. Knowing the dollar figure for such total incurred costs before entering into settlement negotiations is wise, as is having an understanding of the estimated costs of providing notice and other costs associated with implementing the settlement (which should be provided by settlement administrators in their bids).

Consumer Class Actions: 14.8.10.1 Generally

In exchange for settlement relief, plaintiffs in a class action may release claims arising from the transactions on which the case is founded and that were or could have been pleaded. The defendant will normally want at least a release of the claims alleged in the complaint, regardless of the legal theory, and will want the release to cover the specific transactions on which those claims were based.

Consumer Class Actions: 14.8.10.3 Specific Releases to Avoid

The plaintiff’s counsel should not allow any release phrased in vague terms, such as “all claims which could have been brought,” unless this is tied to the specific transactions that are the subject of the action and would be barred by res judicata if the case had proceeded to judgment.

Consumer Class Actions: 14.8.10.4 Releases Involving Homes

Generally, home cases differ from other consumer actions in that they potentially involve a wide range of legal claims and theories and often include a combination of federal and state laws. For example, a predatory lending case involving a series of abuses will often include federal claims under the Truth In Lending Act (TILA), the Homeownership and Equity Protection Act (HOEPA), the Real Estate Settlement Protections Act (RESPA), and the Equal Credit Opportunities Act (ECOA).

Consumer Class Actions: 14.8.11 Second Right to Opt Out

When a contested class motion has previously been granted, and class members received notice of their right to opt out of the class action at that time, counsel should nevertheless consider whether to seek to include in the settlement agreement a term affording class members a second opportunity to opt out of the settlement.

Consumer Class Actions: 14.8.12 Blow Provisions

Some settlement agreements contain a “blow” provision wherein, if the number of opt outs exceeds a certain percentage of the total number of class members, the defendant has the discretion to terminate the settlement. Defendants have an interest in negotiating such provisions, as a large number of opt outs may undermine the goal of global resolution, while plaintiffs generally resist including them.

Consumer Class Actions: 14.8.14 Non-Publicity Clauses

In a consumer class case involving a small class or a small defendant business, the defendant may ask for a non-publicity clause as a condition of settlement. (In larger cases, publicity may be generated even before settlement negotiations begin.) The defendant seeks such a provision because the published settlement notice has the potential to discourage some consumers from doing business with the defendant.

Consumer Class Actions: 14.8.15 Defendants Required to Notify Government Officials Promptly

As noted above, the Class Action Fairness Act of 2005 (CAFA) established new requirements for class actions in federal courts for cases filed after February 18, 2005. One of these is the obligation for defendants to notify federal and state agencies as to the filing of a proposed class action settlement. This obligation applies to all class action settlements, not just those in which the CAFA is the basis for the federal court jurisdiction.