Lost Wages/Lost Income. Money paid for lost income is taxable.
Amounts received as compensation for physical injury or sickness are federal-income-tax-free. This means any awards received for pain and suffering, emotional distress, impairment, medical bills, etc. is tax free. The method of how the funds are received also do not play a role. The money can be the result of a court awarded verdict or an out-of-court settlement.
Surprisingly, lost wages are usually considered tax-free as well despite the fact that they would have been taxed had they been earned normally.
Non-tax-free payments are those paid as interest from the time you were injured up until the time you receive them such as pre-judgment interest paid on an award. Also, non-tax-free items include payments for injuries such as harassment, discrimination, libel, slander, wrongful termination and invasion of privacy. These are so-called non-physical personal injuries. Punitive damages are also taxable although they are related to physical injuries which were not taxable.
Psychological Injuries. Money paid for psychological injuries may be taxable. The U.S. Court of Appeals for the District of Columbia in Murphy and Leveille, Appellants v. IRS and USA, Appellees, reversed a decision that money paid for psychological injuries is not taxable. The court ruled that the personal injury award Ms. Murphy received was "within the reach of the congressional power to tax under Article I, Section 8 of the Constitution", even if the award was "not income within the meaning of the Sixteenth Amendment". The U.S. Supreme Court denied review of the decision on April 21, 2008.
Emotional Distress Under Current Law. Emotional distress does not in itself constitute a physical injury or illness for purposes of income exclusion. However, if the emotional distress is the result of a personal physical injury, amounts received for emotional distress are not taxable. Also, even if emotional distress is not the result of a physical injury, amounts received for emotional distress are not taxable to the extent they do not exceed the amount paid by the plaintiff for medical care attributable to the emotional distress. I.R.C. ?104(a) (flush language). It is not clear whether the 1996 Act would exempt an award allocable to future medical expenses. See Niles v. U.S., 520 F. Supp 808 (D. Cal. 1981) aff'd. 710 F.2d 1391 (9th Cir. 1983) for a discussion of this issue under prior law.
1. Symptoms. A footnote to the legislative history of the 1996 Act states that emotional distress includes physical symptoms (e.g. insomnia, headaches, stomach disorders)
Physical, personal-injury damages are excluded from gross income and are not taxable
Physical, personal-injury damages are excluded from gross income and are not taxable. Internal Revenue Code section 104(a)(2) provides that exclusion. Any settlement amounts that are received, whether as a lump-sum or as periodic payments, on account of a physical personal injury likewise are excluded from gross income and do not appear on your income tax return.
The attorney's fees and costs that you pay to recover the physical, personal-injury damages are not deductibleNeither the Code nor the legislative history defines "personal physical injury." Black's Law Dictionary defines it as "bodily harm or hurt, excluding mental distress, fright, or emotional disturbance." 1304 (Rev. 4th ed. 1968) The Internal Revenue Service defines it as "direct unwanted or uninvited physical contacts resulting in observable bodily harm such as bruises, cuts, swelling, and bleeding." (PLR 200041022 (July 17, 2000)).
Generally, punitive damages are taxable even
if they are awarded in connection with a predicate claim under which damages are nontaxable (such as personal physical injury).
See O'Gilvie v. Comm., 519 U.S. 79 (1996). However, punitive damages are not taxable when they are received in a wrongful death action if the applicable state law (as in effect on September 13, 1995 without regard to any modification after such date) provides, or has been construed to provide by a court of competent jurisdiction pursuant to a decision issued on or before September 13, 1995, that only punitive damages may be awarded in the wrongful death action. I.R.C. ??104(a)(2), 104(c) as amended by the 1996 Act. See also, N.O. Whitley, T.C.M. 1999-124 (suggesting, in dicta, that all punitive damages under Connecticut and Michigan law could be excludable); PLR 200107019 (
Lost Profits Versus Goodwill.
1. Lost Profits Versus Goodwill. Claims which arise in a business context often involve elements relating to both lost profits and damage to identifiable assets, such as goodwill. The burden is on the taxpayer to demonstrate the existence of an asset, as well as damage thereto, in order to avoid treatment of an Award as ordinary income. Rev. Rul. 75- 527, 1975-2 C.B. 30. Raytheon Corp. v. Comm'r, 144 F.2d 110 (1st Cir. 1944). See also Messer v. Comm'r, 438 F.2d 774 (3d Cir. 1971); Milenbach v. Comm'r, 318 F.3d 924 (9th Cir. 2003) rev'g in part 106 T.C. 184 (1996) ($4 million received by Oakland Raiders from City of Oakland in settlement for damage claim stemming from the two years the team was prevented from moving to Los Angeles treated as substitute for lost income).
2. Return of Capital. To the extent that the amount received for damage to an identifiable asset does not exceed the taxpayer's basis in the asset.
Acquired Legal Claims
Recent opinions of the Seventh Circuit and the Tax Court suggest that a different rule may apply to settlement of an acquired legal claim. Nahey v. Comm'r, 196 F.3d 866 (7th Cir. 1999) aff'g 111 T.C. 256 (1998). The taxpayer in Nahey acquired all the assets of a corporation, including a breach of contract claim against Xerox related to installation of a new computer system. Without addressing the "origin" of the claim against Xerox, both courts concluded that taxpayer necessarily realized ordinary income because the extinguishment of the claim did not amount to a sale or exchange. One commentator has suggested that the Seventh Circuit and Tax Court's holding is "incompatible with" the origin of the claim doctrine. See David B. Flassing, From Fahey to Nahey: Wandering Off the Origin of Claim Path in Settlement of Acquired Legal Claims, TAXES - THE TAX MAGAZINE, Aug. 2002, at 35. The Nahey rule also suggests that a plaintiff may recognize capital gain on any sale o
Allocations Between Taxable and Nontaxable Claims
Where an Award is based on more than one claim, allocation of the
Award among the various claims has the most significant tax consequences if both taxable and nontaxable claims are involved.
In such a case, successful allocation to the nontaxable claim saves the plaintiff income taxes and (depending on the claim) might also save both parties employment taxes. However, since Federal law was amended to limit nontaxable claims to those involving physical injury or physical sickness, opportunities to make allocations between taxable and nontaxable claims have become severely limited.
1. No Allocation in Settlement Agreement. Absent a specific allocation in a settlement agreement, courts will look to the plaintiff's complaint and the intention of the payor to allocate an Award among various asserted claims. See, e.g., Francisco v. U.S., 267 F.3d 303 (3d Cir. 2001); Rev. Rul. 85-98, 1985-2 C.B. 51 (lump sum settlement procee
TAX CONSEQUENCES OF CONTINGENT FEE PAYMENTS
Background. Recent cases brought attention to problems that affect the tax treatment of contingency fee arrangements in the employment discrimination context. Prior to enactment of the 2004 Tax Act (discussed below), in a majority of Circuits, a plaintiff was entitled only to a miscellaneous itemized deduction for the contingent fee payment, the value of which was limited (often substantially) because of (i) the 2% threshold on miscellaneous itemized deductions under I.R.C. ?67, (ii) the phase out of deductions for high-income taxpayers under I.R.C. ?68, and (iii) (most significantly) the non-deductibility of such fees for purposes of the alternative minimum tax ("AMT") under Code ?56(a); 56 (b)(1)(A)(i). See Hukkanen-Campbell v. Comm'r, 274 F.3d 1312 (10th Cir, 2001), cert denied, 122 S.Ct 1915, (no AMT deduction for contingent fee paid to attorney's despite "unfair" result)
PROPOSED REGULATIONS ON REPORTING PAYMENTS TO ATTORNEYS
PROPOSED REGULATIONS ON REPORTING PAYMENTS TO ATTORNEYS
A. Background. On May 17, 2002, the Internal Revenue Service issued proposed regulations (the "2002 Proposed Regulations") concerning reporting requirements for certain payments to attorneys. Prop. Regs. ?1.6045-5. The 2002 Proposed Regulations were in response to the comments generated by previously proposed regulations published in the Federal Register on May 21, 1999. The 2002 Proposed Regulations will apply only to payments made during the first calendar year that begins at least two months after the date of publication of the final regulations in the Federal Register. In the meantime, payors of awards to attorneys may use the Proposed Regulations as a safe harbor. A payor of an Award to an attorney should not simply do nothing until the Proposed Regulations go into effect, because the requirement to report payments to attorneys is statutory. See I.R.C. ?6045(f).
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