Few personal injury lawyers have degrees in tax law or accounting. While having advanced knowledge of tax law is not a requisite to the proper handling of a personal injury case, having a basic understanding of potential tax consequences is. To perform up to par, the personal injury lawyer must know which elements of a settlement may be taxable and address the issues accordingly. Anything less falls below the professional standard of care and may have serious negative consequences.
CAVEAT: We do not give tax advice to our clients and we are not giving it in this blog. The information contained in this blog should be used for guideline purposes only rather than as definitive tax advice. For definitive advice on these issues, consult a tax lawyer or accountant.
There are numerous areas in personal injury settlements with potential income tax consequences: 1) punitive damages; 2) damages for emotional distress; 3) the consideration paid for a confidentiality agreement; (4) money paid to compensate for lost income; and (5) money paid to compensate for medical expenses.
A starting point for the legal authority on this topic is Section 104 of the Internal Revenue Code, which reads as follows:
§ 104. Compensation for injuries or sickness.
(a) In general. Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 [IRC Sec. 213] (relating to medical, etc., expenses) for any prior taxable year, gross income does not include–
(1) amounts received under workmen’s compensation acts as compensation for personal injuries or sickness;
(2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness;
(3) amounts received through accident or health insurance (or through an arrangement having the effect of accident or health insurance) for personal injuries or sickness (other than amounts received by an employee, to the extent such amounts (A) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (B) are paid by the employer);
(4) amounts received as a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country or in the Coast and Geodetic Survey or the Public Health Service, or as a disability annuity payable under the provisions of section 808 of the Foreign Service Act of 1980 [22 USCS § 4048]; and
(5) amounts received by an individual as disability income attributable to injuries incurred as a direct result of a terroristic or military action (as defined in section 692(c)(2) [IRC Sec. 692(c)(2)]).
If the IRS decides to scrutinize a settlement for tax consequences, the taxpayer bears the burden of proving what aspects of a personal injury settlement are non-taxable. See Internal Revenue v. Schleier, 515 U.S. 323 (1995). Relevant evidence may include the pleadings, discovery in the case, and the settlement agreement. While it may be good practice for the Plaintiff to have an allocated agreement, meaning one in which the settlement proceeds are broken into component parts for the various damage elements (e.g., personal injuries; economic losses (wages and medical), punitive damages), the exercise is not dispositive of the issue. See Bagley v. Commissioner of Internal Revenue, 121 F.3d 393 (8th Cir. 1997) (The court held: “when assessing the tax implications of a settlement agreement, courts should neither engage in speculation nor blind themselves to a settlement’s realities”) and Delaney v. Commissioner, 99 F.3d 20, 23-24 (1st Cir. 1996) (court must look beyond language of settlement to determine ‘in lieu of what’ for damages paid”).
Florida’s punitive damages statutes are contained in Chapter 768. While pleading punitive damages may increase settlement value, it will also create exposure for tax consequences. The advantages should be weighed against the disadvantages. If punitive damage allegations remain in the pleadings at the time of settlement, it might be advisable to allocate in the settlement agreement a portion for these damages. If the allocation is reasonable in relationship to the facts, the designation may persuade the IRS favorably.
The exclusion of damages in Section 104 for “physical injuries” or “physical sickness” does not include emotional distress damages which are unrelated to physical injuries. See Rivera v. Baker West, Inc., 430 F.3d 1253, 1256 (9th Cir. 2005). A clear example of this type of damage arises in a case claiming intentional infliction of emotional distress. Another example, one in which our firm is currently involved, is for emotional distress arising out of the mishandling of a dead body. Our client’s dead mother’s body was negligently allowed to decompose by the funeral home. Our client saw the decomposed body and a desired viewing could not be held. She suffered emotional distress from the experience. The emotional distress illustrated above is not the same as the pain and suffering claimed in the ordinary personal injury case in which clients recover damages for both physical injuries and the emotional distress resulting therefrom, because this type of emotional distress arises “on account of personal injuries.”
Confidentially provisions in settlement agreements have become boilerplate. Violating the terms carries consequences. However, of greater practical concern are the tax consequences. in Amos v. Commissioner of Internal Revenue, 2003 Tax Ct. Memo LEXIS 330 (Dec. 1, 2003), a personal injury lawsuit was brought against Chicago Bulls basketball player Dennis Rodman for kicking a cameraman during a basketball game. The case was resolved under a confidential settlement for $200,000. The settlement agreement did not reflect how much of the settlement was being paid for the cameraman’s physical injuries, and how much was being paid as consideration for his agreement that the settlement be confidential. The IRS took the position that the entire $200,000 settlement was includible in the taxpayer’s gross income, with the exception of perhaps a nominal sum of $1. That was because the petitioner’s physical injury were minimal. The court held that $80,000 of the settlement was for the confidentiality agreement, and the plaintiff was required to pay income tax on that amount.
Again, although the IRS is not bound by the terms of a settlement agreement, the better practice is to allocate an amount in the agreement paid for the confidentiality. Confidentiality is often an afterthought during settlement discussions, with the language being part of a form release more as boilerplate than being of real concern. Depending on the circumstances, we typically allocate $500 to the confidentiality provision.
Economic Compensation — Loss of Income and Medical Expenses
IRC section 104(a)(2) provides for an exclusion from gross income for damages received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injury or sickness. The Service has consistently held that compensatory damages, including lost wages, received on account of a physical injury are excludable from gross income. Rev. Rul. 85-97, 1985-2 C.B. 50, amplifying Rev. Rul. 61-1, 1961-1 C.B. 14. See also Commissioner v. Schleier, 515 U.S. 323, 329-330 (1995), in which the Supreme Court, employing a similar set of facts as the ruling, held that medical expenses not previously deducted, pain and suffering damages, and lost wages received by accident victim are excludable from income.
If an action has its origin in a physical injury or physical sickness, then all damages (other than punitive) that flow therefrom are treated as payments received on account of physical injury or physical sickness whether or not the recipient of the damages is the injured party.
The facts of each case ultimately control. Proper planning can minimize the tax burden.
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Jeffrey P. Gale, P.A. is a South Florida based law firm committed to the judicial system and to representing and obtaining justice for individuals – the poor, the injured, the forgotten, the voiceless, the defenseless and the damned, and to protecting the rights of such people from corporate and government oppression. We do not represent government, corporations or large business interests.
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