Lexington Ladder Company – Tax Ramifications of Lawsuit Judgment

As you are aware, Lexington Ladder Comp is an audit and tax client of our firm. The company is a C corporation and has a calendar year end. Our firm prepares the Form 1120 for Lexington.

Lexington has been a manufacturer of metal ladders for over 50 years. Its products are sold at retail at large hardware and home supply stores such as Lowe’s and Home Depot.

Lexington has been profitable over its history. We have prepared the company’s tax returns beginning with its year ended Dec. 31, 2003.

Four years ago, a woman, Norma Young, fell off a 6 foot Lexington ladder that her husband had purchased from Ace Supply, a hardware store located in Denver, Co. Mrs. Young was standing on the top step of the ladder hanging Christmas lights on her house when she fell. She suffered injuries to her spinal cord and is unable to work and care for her family.

Mrs. Young filed a product liability suit against Ace Supply and Lexington in Federal District Court in Denver, CO., Young v. Lexington Ladder Company. On Sept. 17, 2013, a jury awarded the plaintiff Mrs. Young $25 million in damages. The jury allocated 70% of the responsibility to Lexington (17.5 M), 25% to Ace Supply (6.25 M), and 5% to the plaintiff Mrs. Young (1.25 M).

Lexington’s management is saddened for Mrs. Young, but the vehemently deny that Lexington’s ladder is faulty. The company’s position was the ladder was not defected and it left Lexington’s factory containing a clearly marked warning label that stated “Do not stand above the second step from the top.” However, someone removed the warning label after the ladder left Lexington’s factory. Lexington is appealing the decision, but it does not expect the appeals court to hear the case until mid-2014.

In the meantime, Lexington must deal with the ramifications of the ruling stands. The company does have product liability insurance which will cover up to $10 M of the judgment. However, that still leaves a $7.5 M shortfall if the appeals court affirms the judgment.

Lexington’s chief financial officer, Miguel Lopez wants to know the timing and amount of any tax deduction relating to the $17.5 M jury award allocated to Lexington. In addition, the award is most likely to create a net operating loss in the year in which it is deducted.

Requirements:

problem 1: Whether Lexington can deduct the lawsuit judgment for income tax purposes, and if so, in what year can it claim the deduction?

problem 2: If the deduction creates a net operating loss, can the loss be carried back, and if so, to what tax years?

Additional Instructions:

a) Use RIA checkpoint as a research tool.
b) The memorandum should follow the Facts, Issues, Conclusions, Support and Analysis, and Action to be Taken format.
c) Cite primary authority in your memorandum.