Lawsuit Awards and Settlements: IRS Tax Law

With tax day fast approaching, Weitz & Luxenberg wants to ensure our clients have all the information they need to understand how to report their large settlements and lawsuit verdicts to the IRS. This information from the Internal Revenue Service does not consitute legal advice. We provide this document for informational purposes only. If you need help with your taxes, contact a tax attorney or an accountant. To file a personal injury lawsuit, click here.

5. Modify exclusion of damages received on account of personal injury or sickness (sec. 1605 of the bill and sec. 104(a)(2) of the Code) Present Law

Under present law, gross income does not include any damages received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injury or sickness (sec. 104(a)(2)).

The exclusion from gross income of damages received on account of personal injury or sickness specifically does not apply to punitive damages received in connection with a case not involving physical injury or sickness. Courts presently differ as to whether the exclusion applies to punitive damages received in connection with a case involving a physical injury or physical sickness.22 Certain States provide that, in the case of claims under a wrongful death statue, only punitive damages may be awarded.

Courts have interpreted the exclusion from gross income of damages received on account of personal injury or sickness broadly in some cases to cover awards for personal injury that do not relate to a physical injury or sickness. For example, some courts have held that the exclusion applies to damages in cases involving certain forms of employment discrimination and injury to reputation where there in no physical injury or sickness. The damages received in these cases generally consists of back pay and other awards intended to compensate the claimant for lost wages or lost profits. The Supreme Court recently held that damages received could not be excluded from income.23 In light of the Supreme Court decision, the Internal Revenue Service has suspended existing guidance on the tax treatment of damages received on account of other forms of employment discrimination. Reasons for Change

Punitive damages are intended to punish the wrongdoer and do not compensate the claimant for lost wages or pain and suffering. Thus, they are a windfall to the taxpayer and appropriately should be included in taxable income. Further, including all punitive damages in taxable income provides a bright-line standard which avoids prospective litigation on the tax treatment of punitive damages received in connection with a case involving a physical injury or physical sickness.

Damages received on a claim not involving a physical injury or physical sickness are generally to compensate the claimant for lost profits or lost wages that would otherwise be included in taxable income. The confusion as to the tax treatment of damages received in cases not involving physical injury or physical sickness has led to substantial litigation, including two Supreme Court cases within the last four years. The taxation of damages received in cases not involving a physical injury or physical sickness should not depend on the type of claim made.

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²² The Supreme court recently agreed to decide whether punitive damages awarded in a physical injury lawsuit are excludable from gross income. O'Gilvie v. U.S., 66F.3d 1550 (10th Cir. 1995), cert. granted, 64 U.S.L.W. 3639 (U.S. March 25, 1996)(No. 95-966). Also, the Tax Court recently held that if punitive damages are not of a compensatory nature, they are not excludable from income, regardless of whether the underlying claim involved a physical injury or physical sickness. Bagley v. Commissioner, 105 T.C. No. 27 (1995).

²³ Schleier v. Commissioner, 115 S.Ct. 2159 (1995).

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see also:

Ch.5: 3rd Party IRS Tax Law: Lawsuit Awards and Settlements, how to report your compensation
IRS-Tax day help with your large settlements & verdicts - Chapter 5

Ch.4: Information IRS Tax Law: Lawsuit Awards and Settlements, how to report your compensation
IRS- Tax day information on your large settlements & lawsuit verdicts

Tax Law IRS Tax Law: Lawsuit Awards and Settlements
IRS Information: Large settlements and lawsuit verdicts