The Volkswagen emissions scandal settlement agreement is stirring perhaps one of the greatest accounting debates in the history of the automotive industry. While this might not sound as exciting to any casual observer, the results could benefit Volkswagen dealers astronomically as far as tax outcomes are concerned. While the determination of the settlement amount’s taxable nature is currently undefined, there is a much stronger case now for capital gains tax treatment (20% tax rate) as opposed to ordinary income tax treatment (39.6% tax rate) based on the culmination of various tax minds at work and based on multitudes of tax research being done (IRS Pub. 550 70).
Not to be overlooked is the ability to offset capital gains with capital losses, another potentially significant benefit of capital gains treatment (Congress 1). If we look at the numbers on the surface, we are talking about approximately $364,000 in tax savings on average, which would be significant to the dealers. For dealers who have already signed the Individual Release of Claims document, there may be some significant tax implications for the 2016 tax year despite the fact that not all of the money will actually be received in 2016. Therefore, it is important to determine the respective tax implications ahead of time for tax planning purposes and it is critical to mention that every dealer’s situation is unique and needs to be handled individually.
ORIGIN OF CLAIM DOCTRINE AND CAPITAL GAINS TAX TREATMENT
The capital gains tax treatment argument has now become significantly more favorable due to a few synergistic variables involving settlement agreement semantics, case law and supplementary materials. The starting point for determining the tax treatment of a settlement payout is predicated on the origin of claim doctrine, or the reason for the legal claim (Shechtman 2) (IRS Pub. 4345 1).
In the case of the Volkswagen settlement agreement, it explicitly states that the compensatory payments to the dealers are “for alleged diminution in value of franchise dealers’ capital and goodwill (Hagens et al. 4).” It would be tough however to postulate capital gains tax treatment solely based on the origin of claim doctrine because there exists within the Internal Revenue Code a sale or exchange requirement of property in order to establish capital gains tax treatment (Congress 1). Hypothetically, if the origin of claim doctrine was the primary source for rendering capital gains tax treatment, the Service could still posit in the Volkswagen case that lost profits is the actual damage caused by the TDI emissions infraction. If such a ruling were granted in the courts, a resultant ordinary income tax treatment would be attached to the settlement income. There exist court cases containing multifaceted origins of claim with complex variables where settlement amounts were allocated between ordinary income and capital gains.
SALES AND EXCHANGE REQUIREMENT AND CAPITAL GAINS TAX TREATMENT
The next biggest concern is that the Internal Revenue Service may contest the position of capital gains tax treatment on the VW payouts positing the argument that the sale or exchange attribute is not present in these transactions. Evidentially, there is corroborating case law where the courts have ruled and converted capital gains to ordinary income tax treatment solely based on this lack of sale or exchange attribute even when the origin of claim in those cases were capital in nature.
There is some good news though despite this seemingly steep uphill battle for capital gains tax treatment of the VW payouts. There simultaneously exists case law where capital gains tax treatment was successfully asserted and the courts’ reasoning showed a complete disregard for the sale or exchange requirement. Additionally, there are even memoranda on cases published by the IRS themselves where they too demonstrated a logic that failed to refer to the sale or exchange requirement (Jensen 1). It will be through the exposure of such court decisions and IRS administrative positions that a case for capital gains tax treatment can be fortified.
There is still a lot of current discussion and uncertainty on the subject matter yielding no consensus. Also, there is no direct court precedent related to this type of settlement agreement or official published IRS interpretation on these VW settlement payouts. However, there exists the possibility that the IRS may be approached to review and release such official published interpretation. It is only a matter of time before these issues are addressed and it is currently up to you and your tax advisor to determine how you will handle the pending settlement proceeds and their taxable nature should no position be established in the near future.
- Internal Revenue Service. Publication 550, 2016.
- Congress. Title 26 Subtitle A Chapter 1 Subchapter P Part III § 1222.
- Shechtman, David. “Tax Aspects of Litigation.”Philadelphia Bar Association
- Internal Revenue Service. Publication 4345. 2015.
- Hagens Berman Sobol Shapiro LLP, Sullivan & Cromwell LLP et al. Volkswagen Branded Franchise Dealer Class Action Settlement Agreement and Release. 30 September 2016.
- Jensen, Ronald H. “Can You Have Your Cake and Eat It Too? Achieving Capital Gain Treatment While Keeping the Property.” Pace Law Faculty Publications, 2007
Author: Peter Goodrich
Peter Goodrich joined Rosenfield and Company in 2015, deepening the firm’s bench strength in Tax Services. Peter graduated from Queens College with a dual major in both Accounting and Physics. After graduation he served as a Tax accountant for a public firm in New York before making the transition to Rosenfield and Company in his search for a position with a progressive firm.