Taxability of Damages

By Hanson, Randall K.; Smith, James K. | The CPA Journal, May 1998 | Go to article overview

Taxability of Damages


Hanson, Randall K., Smith, James K., The CPA Journal


In Brief

New Limits on the Exclusion from Taxability

Damages may be recovered under either breach of contract or tort claims. Tort claims have given rise to the largest and most publicixed judgments. Such claims may arise out of theories of intentional torts, negligence, or strict liability. Both intentional torts and strict liability claims may give rise to punitive damages.

Prior to amendment, IRC section 10(a)(2) allowed exclusion from taxability for any damages receirved on account of personal injury or sickness. The Small Business Job Protection Act of 1996 amended this section to limit this exclusion to those damages received for personal injury or physical sickness. A second change requires punitive damages to always be taxable. These changes are effective for all damages received to always be taxable. These changes are effective for all damages received after August 20, 1996.

The taxability of damages received prior to that date are affected by two Supreme Court decisions. In one case involving age discrimination, the court held that all damages received were taxable because they were not received because of personal injury or sickness nor was the case based on tort or tort type rights. In a second case, the court held that punitive damages were taxable because they were not received on account of personal injuries or sickness. Within the last two years there have been major changes to the way proceeds of lawsuits are taxed. The Small Business Job Protection Act of 1996 amended IRC Sec. 104(a)(2) and the United States Supreme Court rendered two decisions clarifying how the proceeds of lawsuits are taxed. The most recent decision was decided in December 1996. Since the amended IRC Sec. 104(aX2) and the Supreme Court decisions make more damages taxable, there will be increased pressure on attorneys and accountants to find ways to structure settlements so as to minimize the tax effect of successful claims.

The most common theories asserted in seeking to recover civil money judgments are breach of contract claims and tort claims. Of these two theories, it is tort law that is most commonly criticized and is also the theory that has given rise to the largest and most publicized judgments. Recent tort cases that have received extensive media exposure are the McDonald's spilt coffee case and the General Motors pickups with their exploding gas tanks. Cases such as these have accelerated the call for tort reform to rein in what are viewed as outrageous decisions. Legal reform is slow to develop, and, in the meantime, there are huge numbers of tort claims being commenced, litigated, and settled every day.

To fully understand and appreciate the tax rules relating to damage awards, it is important to have a working understanding of the common tort law theories and the damages commonly received for these theories. Understanding tort law concepts is also important because Treasury regulations exclude from gross income payments received as a result of tort or tort-type claims. After examining the various tort theories, we will review the taxation of these tort claim proceeds in light of the recent Supreme Court decisions. Finally we will explore settlement structure strategies.

Tort Theories and Common Damages

Torts can be defined as "civil wrongs against individuals which are not based on breach of contract claims." The basic premise is that individual rights should be protected from harm. There are three categories of tort theories that are recognized in almost every state. They are intentional torts, negligence, and strict liability. Each of these theories will be briefly examined and contrasted.

Intentional Torts. Intentional torts include a broad group of wrongs that are the result of intentional bad acts. The common theme consistent in all intentional torts is the intent to harm another person. Common examples include assault and battery, false imprisonment, defamation, trespass, malicious prosecution, invasion of privacy, intentional infliction of emotional distress, intentional interference with contract rights, and fraud. …

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