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Naqvi v. Rossiello

March 29, 2001


The opinion of the court was delivered by: Justice South

Appeal from the Circuit Court of Cook County.

Honorable Kathy M. Flanagan, Judge Presiding.

This appeal arises from an order of the circuit court of Cook County granting summary judgment and dismissing plaintiff's legal malpractice action against defendants.

Defendants are attorneys licensed to practice law in the State of Illinois. In August of 1988, plaintiff retained them to represent him in a retaliatory discharge action against his employer. A complaint was subsequently filed by defendants on August 12, 1988, in the United States District Court for the Northern District of Illinois, Eastern Division, alleging that plaintiff, a bookkeeper and accountant by education, training and profession, was employed by the employer-defendant until July 5, 1988, when he was "wilfully" and "maliciously" discharged in retaliation for his refusal to engage in illegal activities and wrongful acts which would have been violations of the Internal Revenue Code (IRC) of the United States (26 U.S.C. §104(a)(2) (1994). The complaint further alleged that as a direct and proximate result of plaintiff's dismissal, he was deprived of compensation, bonuses and benefits and suffered humiliation, embarrassment and mental distress. The prayer for relief sought compensatory, punitive and exemplary damages. On January 9, 1992, defendants advised plaintiff that his former employer was offering to settle the case and that the proceeds from this settlement would be nontaxable. Plaintiff agreed to settle the case, and an agreement and release were signed on April 8, 1992.

On August 16, 1995, more than three years after the settlement, plaintiff received a letter from the Internal Revenue Service (IRS), advising him that his 1992 individual tax return had been examined, and it was determined that a payment received by him did not appear on that return. Consequently, plaintiff was compelled to submit to an IRS audit.

Subsequently, plaintiff received a letter from the IRS, which stated in relevant part:

"The lawsuit filed by the taxpayer asserted that he was deprived of compensation, bonuses and benefits (economic damages flowing out of his employment relationship) and that he suffered humiliation, embarrassment, and mental distress (traditional tort-like injuries). However, the complaint did not seek separate amounts for each alleged injury. It merely sought general compensatory damages and punitive damages in equal amounts *** for the tort of retaliatory discharge.

The settlement agreement also failed to apportion the lump sum settlement among the specific injuries and made no attempt even to apportion the settlement between the compensatory damages and punitive damages. We believe that the intent of the payor of the settlement was to resolve all of the issues raised by the lawsuit without special negotiation, either friendly or adversarial, to fix the tax treatment of the settlement proceeds. For purposes of our analysis, we will follow the allocation in the underlying lawsuit, treating 50% of the settlement as punitive damages and 50% of the settlement as compensatory damages and will test each category for satisfaction of the requirements for the exclusion under section 104(a)(2) of the Internal Revenue Code."

Plaintiff was required to pay substantial taxes, interest and penalties on the settlement proceeds.

Plaintiff filed a second amended complaint alleging legal malpractice. The complaint alleged that had plaintiff known the entire settlement sum was taxable, he would never have agreed to settle the case for the amount agreed upon and that defendants were negligent by failing to apportion the settlement agreement between the compensatory damages, part of which were for embarrassment, humiliation and mental distress, and punitive damages. The complaint further alleged that by giving plaintiff erroneous tax advice, defendants caused him to incur substantial damages in the form of penalties and interest.

Defendants filed a motion for summary judgment, arguing that plaintiff had failed to allege how he had been damaged. In addressing the apportionment issue, defendants argued that it did not matter whether the settlement was apportioned between punitive and compensatory damages since the IRS determined that both punitive and compensatory damages were taxable. Additionally, defendants argued that the case law had changed from what it was in 1992 when the settlement agreement was reached, and that at the time of the settlement, the proceeds were nontaxable. Defendants maintained that the new law was applied retroactively by the IRS, over which they had no control, and that the tax advice given plaintiff at the time of the settlement was in accordance with the law as it then existed.

The trial court granted the motion for summary judgment, finding that because plaintiff's damages were incurred as a result of case law that did not exist at the time of the settlement, defendant's actions were not the proximate cause of those damages. In its memorandum opinion and order, the court stated in relevant part:

"The issue for the purposes of this legal malpractice case is whether the Plaintiff's damages, the payment of taxes and penalties with regard to his 1992 settlement, were proximately caused by Defendants' failure to structure the settlement to achieve favorable tax- consequences and failure to advise the Plaintiff of the tax consequences with regard to the settlement. The evidence shows that the reason the IRS held that Plaintiff's compensatory recovery was taxable was based on the Schleier case. Schleier was decided in 1995, well, after the settlement in question and after the Defendants' representation of the Plaintiff ceased. It was not the law of the land in 1992 and thus, the Defendants' failure to follow it with regard to the preparation of the settlement and the advice given therewith cannot be the proximate case [sic] of the Plaintiff's subsequent damages.

The IRS also relied on the case of O'Gilvie v. US, 519 U.S. 79 (1996). There it was held that the exclusionary provision of section 104 (a)(2) did not include punitive damages. The issue of the excludability from gross income of punitive damages has be [sic] visited and revisited by courts and congress over the years. The pendulum has swung back and forth between having them be taxable and, under certain circumstances, ...

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