Sidney DeLong, Taxing the Transition from Status to Contract, Part III
Taxing the Transition from Status to Contract in Family Relations, Part III
Sidney W. DeLong
Promissory Estoppel
If a family promise is not construed as a bargain contract and the promisee recovers under a theory of promissory estoppel, then whether the award is taxable will turn on whether it replaces income, such as lost wages or lost profits, that would have been taxable. This can be illustrated by two familiar, non-family cases. In Neiss v Ehlers 899 P.2d 700 (Or. App. 1995), an optometrist sought reliance damages for breach of an unenforceable agreement to form a business. She had given up a profitable practice in Portland and moved to Ashville, where the parties ultimately failed to agree to terms. Insofar as an award would have replaced her lost wages or fees forgone by closing her practice, it would have replaced taxable income. If it had compensated her for moving expenses and other out of pocket losses she incurred by moving from Portland to Ashville and back again, however, it should not have been taxable.
The promissory estoppel recovery should also be taxable if forgone lost profits are used as the measure of the “reliance” loss, as in Walters v Marathon Oil Co., 642 F.2d 1098 (7th Cir. 1981), where the court used that theory to award lost profits from repudiation of a contract to supply petroleum products to a service station. It reasoned that the plaintiff’s reliance caused it to lose the returns on “forgone investment elsewhere” with another supplier. Such commercial profits recovered as damages for promissory estoppel will be taxed as ordinary income.
Sometimes it is not so obvious whether a promissory estoppel award “to prevent injustice” is designed to replace taxable income. In Ricketts v Scothorn 17 N.W. 365 (Neb. 1898), Grandpa gave Granddaughter a promissory note for $2,000 with the expressed hope that she would quit her retail clerk job in reliance on the financial security afforded by the note. She did quit, but he failed to pay the note before his death and she sued his estate to enforce it. The court enforced her claim against his estate under a theory what would come to be known as promissory estoppel.
If Ricketts were litigated today, how should her recovery be taxed? Should it be a non-taxed gift because that was Grandpa’s clearly expressed motive and because it was not given to her in an exchange of any sort? It would have been non-taxable if he had just handed her the cash. Should it be construed as a non-taxable award of damages replacing out of pocket financial losses that she sustained from her detrimental reliance? That depends on what harm she shows. For example, if the award is calculated to replace the (otherwise taxable) wages she forwent when she left her job, it might be held to be taxable income. Granddaughter’s lawyer should endeavor to characterize her recovery as compensation for pecuniary or non-pecuniary losses rather than as replacement for lost wages at her job.
Conrad v Fields, Unpublished Opinion (Minn. App. 2007) presents an even closer case. A law student recovered the cost of law school from a philanthropist who had promised her he would pay her way through school, thereby inducing her to leave her job and enroll in law school. The award of her tuition does not appear to be taxable earned income because it is not the bargained for consideration for goods and services or otherwise “earned” by anything plaintiff did at the defendant’s request. Rather the damages replace for out of pocket expenses and debt incurred by the plaintiff because of the defendant’s tortious breach of a reliance-inducing promise. Thus described, the damages do not replace otherwise taxable income. The accretion to her wealth is large but not taxable because the transaction appears to have been a non-taxable gift.
However, if she calculated damages on the basis of her lost income from the work that she forwent in reliance on the promise, she risks having the award characterized as taxable income. The contract analysis might prove dispositive of the tax question here. Which was it?
Restitution to Prevent Unjust Enrichment.
As is the case with claims for promissory estoppel, family claims for restitution may or may not generate taxable income, depending on whether they result in compensation or reparation. In re Estate of Zent, 459 N.W.2d 795 (N.D. 1990) held that an aged caregiver stated a claim for restitution against the estate of an unrelated decedent for whom she had provided personal care-giving services. She performed the services without an explicit contract or other agreement for payment. She sought to recover the reasonable value of the services to the decedent, measured by the market value of the wages he saved by having her do the uncompensated care-giving work.
Under her litigation theory, the recovery of the value of her services will be ordinary income to the plaintiff even though it is characterized as a payment to prevent unjust enrichment. Of course, the tax liability is an unfortunate result of recontextualizing an equitable claim as a commercial one. If the decedent had left her a sum of money in his will in gratitude for her services, the bequest would not have been taxable to her because it would have been a non-taxable gift. Because he failed to do so, she will be taxed as if she had been a nurse earning wages in his employ.
In In re Marriage of Pyeatte, 661 P.2d 196 (Az. 1983), a divorcing spouse stated a claim for restitution but not for breach of an express contract to provide financial support during post-graduate education. Much of the tax result depends on what theory of plaintiff’s case prevails. Would recovery of these amounts constitute income to her? Or would it be equivalent to the repayment of a loan of funds, producing no income? If the parties had simply performed their promises, no income tax consequences would have resulted from their expenditures on each other’s behalf because no taxable event would have occurred. Does formal enforcement of the contract claim, transmute the financial support they provided and received from imputed income into taxable income?
In Watts v Watts, 405 N.W.2d. 303 (Wisc. 1987) the court recognized a non-marital cohabitant’s claims for value of services provided during relationship under both express contract and restitution theories. These services included childcare, “homemaking services,” and office work in defendant’s business.
Had she succeeded on her claim of an implied marriage, and if the property award would not have been taxed because division of marital property is not a taxable event: it does not convert imputed income into taxable income. But the court rejected her claim of implied marriage rights.
Plaintiff sought payment both as compensation for her labor and on a theory that she acquired a property interest in the couple’s wealth. If the recovery represented the value of her labor, it would be taxable to plaintiff as ordinary income. If the award represented the value of a business partnership between the parties, it would be taxed under partnership tax laws.
“Divorce” of non-married cohabitants can be a tax disaster if it converts into taxable cash the non-taxable value of imputed income generated, shared, and consumed by the parties during the relationship. Whether payments made in such cases is taxable ultimately depends, of course, on IRS rules relating to the tax treatment of divorcing spouses and non-married cohabitants.