Magazine article The CPA Journal

Tax Law Changes for Damages Received on Account of Personal Injury or Sickness

Magazine article The CPA Journal

Tax Law Changes for Damages Received on Account of Personal Injury or Sickness

Article excerpt

After years of litigation related to the taxability of damages received on account of personal injury or sickness, Congress finally decided the issue when it passed the Small Business Jobs Protection Act of 1996 (SBJPA). Under the new law, all punitive damages are taxable. In addition, most damages received for nonphysical injuries are also included in income. Thus, it will be important to consider the distinction between compensatory and punitive damages when negotiating future settlements. Furthermore, firms may need to withhold taxes from the damage awards they pay.

Prior Law

Before the recent amendment by the SBJPA, IRC section 104(a)(2) excluded any damages received in a law suit or in an outside-of-court agreement on account of personal injury or sickness. Some courts had interpreted this exclusion broadly to cover awards for personal injury that do not relate to a physical injury or physical sickness. Courts have also differed as to whether the exclusion applied to punitive damages received in connection with cases involving physical injury or physical sickness. Two Supreme Court cases have recently clarified the taxation of damages attributable to age discrimination and gender discrimination.

In a 1992 case, Burke v. US. (69 AFTR 2d 92-1293), the Supreme Court held that amounts received as a result of sex discrimination were taxable. While the damages in Burke were not excludable, the IRS believed that the Supreme Court made it clear that discrimination would constitute a personal injury if the relevant cause of action provides a tortlike remedy. In response to Burke, the IRS issued Rev. Rul. 93-88, saying that damages received in satisfaction of gender, race, and disability discrimination claims are excludable from gross income.

Later, in the 1995 case of Schleier v. Commissioner (75 AFTR 2d 95-2675), the Supreme Court held that damages received in an age discrimination case were taxable. Furthermore, the Supreme Court stated that its earlier decision in Burke established two requirements that must be met for damages to be excluded: I ) The underlying cause of action giving rise to the recovery must be "based upon tort type rights," and 2) the damages must have been received "on account of personal injuries or sickness." Schleier effectively eliminated the exclusion of damages from all discrimination cases and limited IRC section 104(aX2) to physical injuries or sickness. Reacting to the favorable ruling in Schleier, the IRS suspended Rev. Rul. 93-88. Thus, the SBJPA is essentially a codification of the Supreme Court's ruling that damages from nonphysical injuries are taxable.

Current Law

Punitive damages are above and beyond the amount needed to make a victim whole. Since punitive damages are a windfall to the taxpayer, Congress believes they should not be excluded from income. In addition, Congress feels that taxation of damages in cases not involving physical injury or physical sickness should not depend on the type of claim made. The SBJPA modified section 104 to remedy these perceived problems.

Under the new law codified by the SBJPA, all punitive damages are now taxable. Only compensatory damages received on account of a personal physical injury or physical sickness are excluded from income. All other damage awards for nonphysical damages such as age discrimination, gender discrimination, and injury to reputation are taxable.

If an action haas its origin in a physical injury or physical sickness, then all compensatory damages are excluded, including compensatory damages paid to someone other than the injured party. For example, assume Mike injures his back in an auto accident and receives a $1,000,000 award for medical expenses and lost wages related to his physical injuries suffered in the accident. Nicole, Mike's wife, also receives a $500,000 award for loss of consortium due to Mike's back injury. Since the origin of the claim was a physical injury, Nicole and Mike are allowed to exclude the fill $1,500,000 from their gross income. …

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