Depp-Heard Verdict Offers Lessons on the Tax Impact of Damages

Over the last few months, the defamation lawsuits of Johnny Depp and Amber Heard have received a great deal of attention. In light of the attention these cases have received, particularly amid the recent decisions, it’s worth taking a good look at the tax implications of judgments and settlements in these and other defamation cases.

What Type of Proceeds from a Lawsuit are Taxable?

Based on the Supreme Court decision of United States v. Gilmore, taxation of proceeds awarded for damages is determined based on the “origin of the claim,” or the nature of the remedy sought and the facts upon which that underlying claim is made. This means that the tax treatment of damages awards depends on what the settlement or judgment payment intends to replace, based on such evidence as the language in plaintiff’s filings, pleadings, and the ultimate settlement agreement or court order.

The Internal Revenue Code makes a very clear distinction between types of judgments and settlements with regard to the taxability of proceeds received. Specifically, Section 104(a) states, in part, that if the underlying claim in a particular case is for damages relating to personal physical injury or physical sickness, proceeds received from such a claim are tax-exempt. In contrast, Reg. Sec. 1.104-(c)(1) states that emotional distress is not considered a physical injury or sickness. In broader terms, proceeds received from cases dealing with emotional distress, psychological damage, or loss of reputation are fully taxable.

However, there is a significant exception to the inclusion of such proceeds. Reg. Sec. 1.104-(c)(1) states that damages for emotional distress attributable to a physical injury or physical sickness are excluded from income.

Although the testimony in the cases of Johnny Depp and Amber Heard did not contain great detail about physical abuse that each allegedly did to the other, the cases were clearly defamation lawsuits as each accused the other of damage to their careers. Depp’s lawsuit asserted that Heard’s abuse allegations were an “elaborate hoax” that cost the actor his career and reputation. Therefore, it is clear that Depp’s significant award in his defamation case is taxable; this is also the case for Heard’s smaller award.

Are Payments in a Defamation Suit Tax Deductible?

Generally, payments pursuant to a settlement or judgment when the payment is made by a taxpayer conducting an active trade or business are fully deductible. To be deductible as a trade or business expense, an expenditure must generally be directly connected with the taxpayer’s trade or business. Therefore, if the individual or entity can prove the requisite business nexus, defendants are generally able to deduct settlements or judgments, including the legal fees. In short, those payments would be deductible under Section 162 of the Internal Revenue Code.

This tax treatment could even be the same in a defamation case. For example, if a consumer writes an op-ed in a newspaper that is derogatory toward a business and its products, the owner would clearly have a tax-deductible payment if a lawsuit claiming defamation was filed and won in court. The negative press could clearly affect the business’s success and profits.

To determine the deductibility of payments in the Depp and Heard cases, we need to look at the underlying “origin of the claim” as noted earlier. Depp was suing Heard for defamation based on an op-ed she wrote in the Washington Post in which she stated that she was a victim and a survivor of domestic violence. Although the article did not mention Depp by name, his attorneys were able to convince the jury that the article dealt with the personal relationship between Depp and Heard and that the accusations were false.

Is there a direct connection to business in this case? Depp did accuse Heard of damaging his career, while Heard was alleging that she was the subject of physical abuse. In both cases, their reputation in their acting and performing careers are at risk. In contrast, Section 262 disallows a deduction for personal expenses.

In United States v. Gilmore, the court held that divorce litigation expenses were a nondeductible personal expenditure even though, if the taxpayer received an adverse determination by the court, the issue was very likely to destroy the taxpayer’s business. The court noted that the origin of the claim was the divorce litigation and not the potential consequences to the business. Therefore, the court ruled that the litigation expenses were nondeductible personal expenditures.

Based on the origin of claim doctrine, it’s very difficult to argue that payments made in satisfaction of the decision in the Depp and Heard cases are business-related. The origin of the claim of both sides was actually based on their personal relationship and marriage.

Can Taxable Proceeds Received Be Reduced by Offsetting Legal Fees?

The issue addressed in this section can be best addressed by the following situation:

Supposing a taxpayer’s attorney gets paid on a contingent fee basis. The taxpayer receives a $100 award but owes 30% of the amount to his attorney. If fact, the taxpayer will only receive $70, as the attorney’s fee will be paid directly to the attorney. Does the taxpayer report $100 in income and attempt to deduct the $30 on his tax return, or does the taxpayer only need to pick up in income on $70 because he will never receive the additional $30? If the taxpayer is required to pick up the entire amount of $100, he very likely will not get the deduction for the $30 attorney fee, because this would typically be a “miscellaneous itemized deduction,” which are not allowed in computing taxable income as a result of tax reform.

The Supreme Court decided in Commissioner v. Banks that the taxpayer in the above example must include income the entire amount the award and may not deduct the contingent attorney fees. In short, the Supreme Court reasoned that the legal fee is paid from the recovery that is derived from the plaintiff’s cause of action. Therefore, the taxpayer has dominion and control of the entire award, and the entire award must be picked up in income. As miscellaneous itemized deductions are not allowed through 2025, this is a disadvantageous decision for the award recipient. In the Depp and Heard cases, this position could be a difficult result for Heard and a disastrous result for Depp.

Summary

Although, the general consensus is that Johnny Depp was the big winner in the much-publicized trial, once the tax implication is taken into account, the win is actually significantly diminished. The Depp and Heard cases simply underscore the importance of advisers knowing the true tax impact on the court proceedings of their clients.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Lewis Taub is a CPA and a director of tax services in the New York City office of Berkowitz Pollack Brant Advisors and CPAs. He specializes in minimizing taxes for businesses and individuals.

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