May 26, 2016 Practice Points

Precision in Drafting Settlement Agreements is Key to Avoiding Later Challenges

Contract drafting creates risks and challenges, requiring vigilance, especially with respect to tax issues

by Marc J. Zucker

Commercial litigators rarely get involved in the drafting of contracts, preferring instead to leave such tasks to their corporate/transactional colleagues. The distinct roles of litigator and transactional attorney blur, however, when a settlement agreement is drafted. Wading into the unfamiliar sea of contract drafting creates new risks and challenges, and requires corresponding vigilance, especially with respect to hidden (or not so hidden) tax issues. While the tax implications of a settlement are a critical factor for any attorney to consider, proper drafting of a settlement agreement often is the key to avoiding any misunderstanding later on. The Third Circuit made this point loud and clear in its recent non-precedential opinion in White and Williams LLP et al. v. Michelle T. Seidner, et al., C.A. No. 14-4606 (3d Cir. May 16, 2016).

In that case, a law firm partner died, owing the IRS over $800,000 in taxes. The law firm and its related pension funds, some of which were administered by Vanguard and Wilmington Trust, owed more than a million dollars to the law partner's estate, subject to an IRS levy. The law firm then commenced an interpleader action with respect to those funds, naming the U.S. government, the decedent's wife and ex-wife as defendants. The dispute was settled pursuant to an agreement which provided that the U.S. government would accept $775,000 "in full and final payment of all personal tax liabilities owed by Decedent to the United States," and that "the excess sums" would be divided equally between the wife and ex-wife. Another paragraph of the settlement agreement contained caveats noting that the law firm would not be responsible for any tax liability relating to the funds, and the ex-wife did not acknowledge any such tax liability. At the time of distribution, Vanguard and Wilmington Trust set aside a significant percentage of the funds for federal tax withholding, thereby reducing the $229,000 remaining funds to only $44,000 available to be divided between the wife and ex-wife.

While the district court still retained jurisdiction over the underlying dispute, the ex-wife filed a motion contesting the distribution as contrary to the terms of the settlement agreement, or alternatively seeking to set aside the agreement as based on a mistake of fact. The district court found that the agreement was enforceable as written and had been substantially performed.

On appeal, the Third Circuit affirmed. The Third Circuit concluded that this was an issue of contract construction, as to which it could exercise plenary review, rather than contract interpretation, which would require deference to the lower court.

The court held that because the settlement agreement only fixed the payment of the decedent's taxes, and not the tax liability of the fund recipients, the ex-wife could not challenge Vanguard and Wilmington Trust's decision to withhold 20–30 percent of the funds distributed. Moreover, because the settlement agreement provided only that "excess sums" would be divided between the wife and ex-wife, without specifying the amounts of those sums, the ex-wife had no reasonable expectation to receive more than she got. The Third Circuit likewise adopted the reasoning of the district court that "an agreement between private parties cannot relieve a party to that agreement of tax liability, no matter how strongly that party believes they should not be taxed."

While non-precedential, this opinion is a wake-up call that tax liability of all parties to a transaction must be considered when drafting a settlement agreement. Begin by consulting with a tax professional, but don't stop there. Take a hard look at the language of the agreement itself and be sure it is as precise as it needs to be.

Keywords: commercial and business, litigation, contract construction, contract interpretation, interpleader, settlement, tax implications, tax liability, tax withholding

Marc J. Zucker is with Weir & Partners LLP in Philadelphia, Pennsylvania.

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