As tax attorneys in Columbus, Ohio, Nardone Limited routinely assists taxpayers with representation in tax examinations, tax audits, appeals, and civil litigation with the Internal Revenue Service (“IRS”). As part of that representation, our tax attorneys routinely advise clients, and their advisors, to be proactive and anticipate unintended tax consequences of entering into a transaction or settlement. By being proactive and anticipating unintended tax consequences, we avoid the scrutiny of the revenue agent or IRS Appeals Officer when being examined or audited by the IRS. One area where we see taxpayers, and their advisors, fail to be proactive and fail to anticipate unintended tax consequences, is in the area of settlement agreements dealing with both physical and emotional injuries and damages.
Background and General Law
When dealing with settlements of both physical and emotional injuries, we have to closely scrutinize and determine whether or not the damages awarded are included in the taxable income of the person harmed. If we wait until the settlement agreement has been executed, and the case settled, we likely missed our opportunity to plan, and certainly missed our opportunity to ensure that the settlement was entered into in the most tax-efficient manner. The determination of whether or not the damages awarded are included in the taxable income of the person harmed, requires us to analyze Internal Revenue Code Sections 61 and 104.
Section 61 provides, in general, that gross income means all income from whatever source derived. Section 104(a)(2) provides that except in the case of amounts attributable to (and not in excess of) deductions allowed under Section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include the amount of any damages (other than punitive damages) received (whether by suit or agreement) on account of personal physical injuries or physical sickness. Section 104 also provides that for purposes of Section 104(a)(2), emotional distress shall not be treated as a physical injury. But, Section 104 also provides that the preceding sentence shall not apply to an amount of damages not in excess of the amount paid for medical care (described in Section 213(d)(2)(A) or (B)) that is attributable to emotional distress.
Treasury Regulation Section 1.104-1(c) provides, in part, that the term "damages received (whether by suit or agreement)" means an amount received through prosecution of a legal suit or action based upon tort or tort type rights, or through a settlement agreement entered into in lieu of such prosecution. In Commissioner v. Schleier, 515 U.S. 323 (1995), the Supreme Court of the United States ("Court") held that two independent requirements must be met for a recovery to be excluded from income under former Section 104(a)(2):
- First, the underlying cause of action giving rise to the recovery must be "based upon tort or tort type rights." In United States v. Burke, 504 U.S. 229 (1992), the Court concluded that in order for the first requirement to be met, the relevant cause of action must provide the availability of a broad range of damages, such as damages for emotional distress, pain, and suffering.
- Second, the damages must be received "on account of personal injuries or sickness." In Schleier, the Court illustrated the application of the second requirement by way of an example in which a taxpayer who is injured in an automobile accident sues for (1) medical expenses, (2) pain, suffering, and emotional distress that cannot be measured with precision, and (3) lost wages. The Court explained that the second requirement would be met for recovery of (1) the medical expenses for injuries arising out of the accident, (2) the amounts for pain, suffering and emotional distress, and (3) the lost wages as long as the lost wages resulted from the time in which the taxpayer was out of work due to the injuries sustained in the accident.
Rev. Rul. 85-97, 1985-2 C.B. 50, concerns a taxpayer who received damages in settlement of suit for injuries he suffered when he was struck by a bus. The taxpayer’s complaint alleged that as a direct result of being struck by the bus he had been unable to pursue normal employment activities and had lost wages, had suffered and would continue to suffer great pain of body and mind and loss of earning capacity, and had incurred and would continue to incur hospital and doctors' bills. The ruling concludes that the entire amount of the settlement received by the taxpayer was excludable from gross income as amounts received on account of personal injuries under former Section 104(a)(2).
Change in the Law Regarding Settlement Agreements
Section 1605 of the Small Business Job Protection Act of 1996 (the "1996 Act") restricted the exclusion from gross income provided by Section 104(a)(2) to amounts received on account of personal physical injuries or physical sickness. [Emphasis added.] H.R. Conf. Rep. No. 737,104th Cong., 2d Sess. 301 (1996), provides the following explanation of the amendment made by the 1996 Act:
“The House bill also specifically provides that emotional distress is not considered a physical injury or physical sickness. Thus, the exclusion from gross income does not apply to any damages received (other than for medical expenses as discussed below) based on a claim of employment discrimination or injury to reputation accompanied by a claim of emotional distress. Because all damages received on account of physical injury or physical sickness are excludable from gross income, the exclusion from gross income applies to any damages received based on a claim of emotional distress that is attributable to physical injury or physical sickness. In addition, the exclusion from gross income specifically applies to the amount of damages received that is not in excess of the amount paid for medical care attributable to emotional distress.”
Footnote 56 of the Conference Report states, "It is intended that the term emotional distress includes symptoms (e.g., insomnia, headaches, stomach disorders) which may result from such distress." H.R. Conf. Rep. No. 737 at 301.
The term "personal physical injuries" is not defined in either Section 104(a)(2) or the legislative history of the 1996 Act. But, we believe that direct unwanted or uninvited physical contacts resulting in observable bodily harms such as bruises, cuts, swelling, and bleeding are personal physical injuries under Section 104(a)(2). See Black's Law Dictionary 1304 (Rev. 4th ed. 1968) which defines the term "physical injury" as "bodily harm or hurt, excluding mental distress, fright, or emotional disturbance."
Recommendations from Nardone Limited
Recognizing that the term “physical” is very important to the ultimate determination of the proper tax treatment, we have to be cognizant of the original claim raised by the plaintiff at the earliest aspect of the case and properly and consistently communicate with all parties involved regarding the proper terminology. The origin of the claim must be a physical injury. So, the wording involved, both orally and in writing, throughout the controversy and settlement stages, needs to ensure that we are discussing and focusing on the physical aspects of the injury, to the extent they exist. And, we have to ensure we properly evaluate and allocate the damages based upon the actual facts and circumstances, after involving the necessary experts, and not relying solely on what we would like the tax treatment to be in a particular instance. It is all about the objective and proper documentation after considering all the facts and circumstances. We do not want to wait until after the transaction is complete. It needs to happen from the outset.
Contact Nardone Limited
Nardone Limited frequently represents individuals and businesses in state and federal tax matters, including taxpayers who are subjected to an IRS audit or examination. If you are facing an IRS tax audit or examination, or if you wish to learn more about proper documentation regarding settlement agreements to avoid the inclusion of income, contact one of our experienced tax attorneys today. We will thoroughly review your case to determine what options and alternatives are available.