Magazine article The CPA Journal

Lawsuit Awards and Settlements Audit Guide

Magazine article The CPA Journal

Lawsuit Awards and Settlements Audit Guide

Article excerpt

THIS GUIDE WAS DEVELOPED TO PROVIDE LISTS OF ISSUES, explanations of applicable terminology, suggestions for conducting the examination, synopses of related court cases, and exhibits of pertinent forms.

The IRS audit guide on lawsuit awards and settlements is part of the agency's revamped approach to auditing, the Market Segment Specialization Program (MSSP). The fundamental objectives of the MSSP are to increase voluntary taxpayer compliance and to help IRS examiners perform audits more efficiently and effectively by providing technical tax and compliance guidelines for specific industries, classes of taxpayers, or issues (see "The IRS Market Segment Specialization Program," The CPA Journal, February 2001). This most recent audit guide differs from previous guides in that it does not relate to a specific industry or market segment, but rather to a narrow issue that applies only to individuals.

This audit guide resulted from a project concerning a large number of lawsuits in Alabama that had been resolved by verdict or settlement. Early results of the project indicated that most of these substantial lawsuit payments were not reported as taxable income. Hence, this guide was developed to provide lists of issues, explanations of applicable terminology, information on the identification of tax returns with lawsuit payment issues, suggestions for conducting the examination, synopses of related court cases, and exhibits of pertinent forms.

The Audit Guide

The audit guide consists of ten chapters and four appendices. The main issue, the taxability of lawsuit payments, seems relatively simple. IRC section 104(a)(2) specifically addresses income exclusions for any type of lawsuit payments. Prior to 1996, this section excluded from income lawsuit payments for personal injuries or sickness. IRC section 104(a)(2) was amended in 1996 to clarify the taxability of punitive damages without regard to their connection to a physical or nonphysical injury or sickness. The 1996 changes also limited amounts excludable for emotional distress to out-of-pocket medical costs in cases of nonphysical injuries (such as discrimination). The audit guide applies to both pre- and post-1996 lawsuit payments.

The potential audit issues related to lawsuit proceeds are presented in Chapter 1 of the audit guide:

* Proceeds are unreported.

* All punitive damages are taxable.

* Interest portion of proceeds should be reported as income.

* After 1996, the only amounts excludable are those received in a case of physical injury or out-of-pocket costs for medical expenses incurred to treat emotional distress. …

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