Come On, It's for a Personal Injury, It Shouldn't by kgw20645

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									Come On, It’s for a Personal Injury, It Shouldn’t
Be Taxable. Should It?
      Martin H. Abo, CPA/ABV, CVA        of amounts paid for medical care            are excluded if the underlying injury
                                         attributable to emotional distress.         was physical (i.e. loss of consortium or
  Before I become inundated with tax The legislative history of The Small            recoveries for wrongful death).
returns, valuations and other litigation Business Job Protection Act signed
reports, I thought I’d take some                                                        It is now pretty much well settled
                                         into law in 1996, as it related to IRC                          that interest included
time to remind my legal colleagues       section 104(a)(2), provided some
that there truly are “Tax Aspects of                                                                     in a judgment that
                                         useful insight into what was or was not                         has become final
Personal Injury Awards”. That said,      excluded from taxable income because
how delighted I was to help I.C.L.E.                                                                     will be treated as
                                         of “physical injuries or physical                               taxable interest,
with the new medium it chose for a       sickness”. Generally, if the primary
webinar on this very topic. Who better injury is physical, then all resultant                            not to be excluded
to balance out the “Tax accountant”                                                                      under IRC sec
                                         damages (except for punitive damages        104(a)(2). Concerns develop where
then the very seasoned Certified Trial or interest) are excludable. This is the
Attorney, Tommie Ann Gibney Esq.,                                                    an out of court settlement occurs with
                                         case even if the damages are measured       the settlement agreement silent as to
of Andres & Berger? As an aside, I’ve by lost wages. As I mentioned in an
personally never been a big fan of                                                   interest. IRS typically argues that some
                                         article for The Barrister a year or so      portion of the lump sum payments
purchasing the tapes from a seminar      back, the 1996 Act curtailed years
or conference but I do encourage                                                     represents interest income taxable
                                         of confusion and litigation by stating      to the Plaintiff while the taxpayer
you to purchase this hour-and-a-half     that awards for nonphysical injuries
presentation offered by I.C.L.E. The                                                 Plaintiff will take the position that the
                                         will be excluded but only to the extent     entire settlement should be excluded
webinar was strictly audio so you        of amounts paid for medical care
need not worry about the camera                                                      under 104(a)(2) as damages received
                                         attributable to emotional distress - not    “on account of personal injuries”. Even
aspects and I believe the handouts       for the actual nonphysical injury itself
quite insightful. Nope, this is not a                                                so, attorneys should consider stating
                                         (i.e. age and gender discrimination         in their settlements that the award
paid advertisement but a suggestion      or harassment cases). Such
from a very practical accountant. What exclusions would include medical              is “without interest” although such
follows are some excerpts from my                                                    a practice is certainly not decisive.
                                         care necessitated by a non-physical         While there may be an assumption
portion.                                 injury (i.e. psychiatry or therapy for      there is no interest in a lump sum
  Internal Revenue Code (IRC)            emotional distress resulting from a         personal injury settlement reached
section 61 states that all income from   wrongful discharge, medicines for           before the actual trial, appreciate
whatever source derived is taxable       resulting stress, dental bills resulting    how easy it is for the IRS to glean
income, unless specifically excluded     from teeth grinding, etc.). However,        an interest component from a jury
by another code section. The only        if the primary injury is not physical,      verdict, which specifies compensatory
provision which specifically addresses then the resultant damages are not            damages along with stated interest
income exclusions for any type of        excludable even if the action caused        computations. Structured settlements
lawsuit proceeds is IRC section 104(a) emotional distress, which might result        (i.e. damages awards paid in a series
(2) which excludes from income           in headaches, ulcers, teeth grinding,       of periodic payments and not in a
amounts paid by suit or agreement        insomnia, etc. It’s even interesting to     lump sum) received on account of a
for personal injuries or sickness.       note in the Conference Report that          personal physical injury will enable
Awards for nonphysical injuries are      injuries resulting to other third parties   the recipient to exclude the entire
not excludable except to the extent
                                                                                                    Reprinted from The Barrister
amount of the periodic payments, even      I would imagine trying to substantiate     2006 the Court of Appeals agreed that
though such payments clearly include       the tax treatment in the initial           Ms. Murphy’s damages for emotional
an interest element.                       complaint is further complicated since     distress were NOT “income” and,
   As I alluded to earlier, the water      the plaintiff’s lawyer often considers     thus, were NOT taxable. The
is still pretty murky on exactly what      several different theories/claims at the   Court found an award limited to
is a “physical injury”? Are ulcers?        outset of a case. Still, the IRS often     making someone “whole” for actual
Are migraines or cluster headaches?        relies on the initial complaint as the     documented losses to physical or
Are strokes? Once again, reading the       most persuasive in allocating damage       mental health was not taxable.
legislative history in the Conference      awards (usually in their favor and not        The three judge Court of Appeals
Committee Reports to the 1996 law          the Plaintiff’s).                          decision was only binding on the IRS
changes revealed that mere symptoms        Then Came Marrita Murphy,                  with similar cases in Washington
of emotional distress such as                                                         DC but it was startling to the tax
stomachaches, headaches or insomnia
                                           et al, v. Internal Revenue                 community as having a significant
do not constitute physical injuries
                                           Service, et al                             “rippling effect”, especially for any
although these three examples were           Marrita Murphy was awarded               cases anticipating damage awards for
not meant to be all-inclusive.             compensatory damages for emotional         “non-physical or emotional/mental
                                           distress and reputation loss when          injuries”. One could easily see how
   A properly worded complaint or
                                           she sued her former employer under         plaintiffs and their attorneys would
settlement agreement can certainly
                                           the whistle blower statutes then in        likely move quickly for similar
aid in the exclusion of the damages
                                           effect for emotional distress and          decisions in other circuits, opening
from gross income. In fact, not
                                           physical damages resulting from her        up the proverbial “floodgates” for so
considering the tax consequences of
                                           employer’s retaliation and illegal         much litigation. The Appeals Court
a damages award can easily lead to a
                                           treatment (or mistreatment). The           came under tremendous pressure from
malpractice claim against the erring
                                           initial award from an Administrative       various federal agencies, judiciary,
attorney. Regardless, I would ask my
                                           law judge and affirmed by the              the accounting and legal communities.
attorney colleagues to consider the
                                           Department of Labor Administrative         For those who can’t easily grasp the
following scenario: a driving instructor
                                           Review Board was for compensatory          tax significance, the cost of settlement
suffers some physical injuries when
                                           damages of $70,000. $45,000 was            will invariably go up when the taxing
he failed to follow standard operating
                                           for “emotional distress or mental          authorities want their “piece of the
procedures with the company vehicle
                                           anguish” and the balance, or $25,000,      pie”. Plaintiffs are willing to accept
under his control. The employer
                                           was for “injury to her professional        lesser “gross” awards if there are less
terminates his employment contract
                                           reputation”. Ms. Murphy reported           or no income tax strings attached
for breach of their rules. The employee
                                           and paid tax on the full amount of         while, conversely, the defendant or
then sues and assume the company
                                           the award. She later filed an amended      his (her) insurer will need to come
agrees to settle for $100,000. The
                                           income tax return seeking refund of        up with less money, as well. After
employee’s attorney may artfully craft
                                           $20,665. When the IRS denied her           the 1996 changes which clarified
the settlement agreement to specify
                                           claim she sued in the U.S. District        that emotional distress damages are
that the employer is paying for the
                                           Court for the District of Columbia in      taxable, it became that much more
personal physical injuries suffered
                                           an attempt to obtain refunds for these     difficult to settle cases. We at Abo and
by the employee, hoping to avoid
                                           taxes she paid on the compensatory         Company, sitting on the sidelines after
taxation of the proceeds. Although
                                           damages for emotional distress             the Murphy decision, saw, perhaps for
such drafting of the settlement
                                           and reputation loss. As I discussed        the first time, the plaintiff’s bar in full
agreement is not conclusive, leaving
                                           earlier, such damages for emotional        agreement with the defense bar.
it open or vague only leaves the IRS
                                           distress are not specifically excluded
an opportunity to easily challenge                                                    What a difference a year
                                           under section 104 and were thus
such treatment. For example, the
Service may claim that the $100,000
                                           considered taxable by the Service.         makes
                                           The taxpayer plaintiff, challenging its      Fast forward from the August 22,
was to compensate the employee
                                           constitutionality, argued that damages     2006 decision in Murphy to July 3,
for the “wrongful discharge”, which
                                           paid with regard to non-physical           2007. Well, in a remarkable reversal
would make the proceeds taxable.
                                           injuries are not “income” and also         of its prior decision, the same court
Properly wording the initial complaint
                                           argued her award should not be taxed       later accepted that any non-physical
as well as the settlement agreement
                                           because she suffered from physical         award should be fully taxable. The
or even asking the Court to allocate
                                           manifestations of her “mental” injury.     Department of Justice asked for a
the damage awards is the best way to
                                           The District Court rejected her plea       hearing en banc (I learned that this is a
help ensure favorable tax treatment.
                                           and, after appealing, on August 22,        hearing before all the members of the
While I’m a CPA and not an attorney,
Court rather than before only the panel      and circumstances indicate that             attorneys should be very cautious
of three judges who made the original        the allocation does not reflect the         when agreeing to personal injury
decision). That same Court vacated           economic substance of the settlement.”      settlements that include confidentiality
its original August 2006 judgment.             A bona fide arm’s-length settlement       clauses. They should at least
I’ll leave it to constitutional rights       agreement among adverse parties             ensure that the tax issues have been
advocates or perhaps employment              allocating specific amounts to specific     considered and properly addressed if
lawyers to argue the intrinsic merits        claims should be honored by the IRS         these provisions must be so included.
of the government’s new arguments.           although they are not bound by the          Plaintiff lawyers are therefore
For us and other tax practitioners,          parties’ allocation and may challenge       well advised to commence any
we’re left to follow what we initially       an unreasonable one. According to the       negotiations, right at the start, noting
envisioned after the 1996 tax law and        IRS’ audit guide “…if damages have          that such confidentiality provisions
before the initial Murphy decision.          been clearly allocated to an identifiable   be stricken. If plaintiff attorneys can’t
Of course, there is no difference in         claim in an adversarial proceeding by       eliminate such confidentiality clauses,
cases where the origin of the claim is       judge or jury, the Service will usually     then, at a minimum, they should
a personal physical injury. The actual       not challenge their character because       seek to keep the language as tight
wording of the initial order from            of the impartial and objective nature of    as possible since defense attorneys
the Administrative Law Judge was             the determinations.”                        frequently put in such clauses
so very critical by his use of phases                                                    automatically. For more on the Amos
                                               On a related note, plaintiffs bar
like “emotional distress or mental                                                       ramifications and suggested legal
                                             as well as the defense bar should
anguish” and “injury to professional                                                     strategies, I’d suggest looking to Ms.
                                             be cognizant that confidentiality
reputation”. These words effectively                                                     Gibney’s presentation and materials
                                             provisions can also be considered
put the nail in the coffin for the                                                       from ICLE’s webinar.
                                             taxable income. Truth be told,
argument that exclusion under section                                                      How’s this for a scary ending? For
                                             I was at Starbucks on a Sunday
104 (a)(2) applied by its terms, with                                                    a summary, why don’t I just list the
                                             morning reading through some of
the IRS emphatically arguing that Ms.                                                    introductory bullet points retrieved
                                             the Murphy commentary when one
Murphy’s injuries were not physical.                                                     directly from the IRS’ special AUDIT
                                             Michael Ringold, Esq. of Dansky
   I can think of two important lessons      Katz & Ringold alerted me to the            GUIDE FOR LAWSUIT AWARDS
to be learned that the Murphy verdict        Amos Case. Previously, personal             AND SETTLEMENTS? I know, I
teaches us. First, settlement may very       injury settlements that contained           know, some feel that we CPAs or your
well be better than a verdict, giving        confidentiality provisions were             tax attorney colleagues are just overly
the plaintiff taxpayer greater flexibility   believed to be fully excluded from          cautious in making issues where there
in structuring a settlement tax-wise.        taxable income as with the rest of the      aren’t. Hey, what follows is the IRS
In addition, counsel can just not be         settlement (except for an interest or       auditor’s roadmap, not mine.
concerned enough over using exacting         punitive component) income under
wording in that perhaps “on account                                                      Issues For Lawsuit Proceeds
                                             section 104(a)(2). Eugene Amos, a
of” is not as clear as one would think       TV cameraman, was run into off-court
                                                                                         Received
(i.e. “on account of physical injury”).      and purposely kicked by basketball            1. Settlement proceeds are
                                             star, Dennis Rodman. Amos required               unreported
Some Additional Thoughts on                                                                2. All punitive damages are taxable
                                             medical attention but, ultimately,
Where We Are                                 Mr. Amos’ and Mr. Rodman’s                       whether received in relation to a
  Absent a specific allocation in a          attorneys negotiated a settlement.               physical or non-physical injury
settlement agreement, courts (and            The settlement contained a general            3. Determine if any of the
the IRS) will look to the plaintiff’s        release and included confidentiality             settlement proceeds are
complaint and the intention of the           provisions. Mr. Amos excluded the                designated as interest, and, if
payor to allocate an award among             entire settlement as proceeds from a             so, such interest is reported as
various asserted claims. According           physical injury. The IRS challenged              income.
to the IRS’ audit guide for Lawsuit          such treatment and the matter was
Awards and Settlements “…many                                                              4. Verify that amounts excluded
                                             appealed. The U.S. Tax Court, with its           from income were received in
lawsuits are settled prior to a jury         decision in Amos v. Internal Revenue
verdict. These settlements should                                                             a case of personal injury. If it
                                             Service, gave its blessing to the IRS            was not a physical injury, the
be closely reviewed, and facts and           in taxing a portion of the settlement
circumstances should be carefully                                                             only amounts excludable under
                                             proceeds from the physical personal              IRC section 104(a)(2) are out
determined. The allocation among             injury award as attributable to the
the various claims of the settlement                                                          of pocket costs for medical
                                             confidentiality provision. Given the             expenses incurred to treat
can be challenged where the facts            Amos decision, plaintiffs and their              emotional distress.
5. For out of court settlements for          7. Verify that the taxpayer reported                               9. The legal fees deducted on
   physical injury cases, determine             taxable amounts at gross rather                                    Schedule A are a tax preference
   if proper amounts were allocated             than reporting them net of legal                                   item for purposes of AMT
   between compensatory and                     fees paid.                                                         (Alternative Minimum Tax).
   punitive damages.                         8. Allowable legal fees should
6. Verify the amount of out of                  be deducted on Schedule A
   pocket expenses excluded for                 as miscellaneous itemized
   emotional distress in a non-                 deductions, unless the origin
   physical injury case (that is                is related to a schedule C
   discrimination, fraud, etc.).                (independent contractor) or a
                                                capital transaction.



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