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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.
Principal Client Services of Abo and Company, LLC
TAX PLANNING AND COMPLIANCE
• Tax planning for individuals, corporations,
partnerships, limited liability companies, estates • Valuations of businesses
and trusts • Analysis and evaluation of opposing experts’ reports
• Tax return preparation and review and independent expert witness testimony
• Assistance with IRS, state and city examinations and ACCOUNTING, AUDITING AND
conflicts, including representation and negotiations to REVIEW SERVICES
resolve disputes • Design of financial statements and internal
• Tax related valuations management reporting systems
FINANCIAL CONSULTING • Audits of financial statements
• Financial forecasts and projections • Compilations and Reviews of financial statements
• Funding assistance, including preparation of business • Budgeting, cash flow, internal control and financial
plans, financing negotiations and communications statement analysis with recommendations.
with lenders and investors and workouts MANAGEMENT CONSULTING
• Merger, acquisition and divestiture services • Profitability analysis
• Transaction structuring for financial and • Strategic business and financial planning
tax purposes and general business advice
• Bank relationship consulting • Bookkeeping operations review
DISPUTE RESOLUTION SERVICES and recommendations.
• Litigation support services • Accounting systems solutions
• Marital dissolutions • Assistance in defining, interviewing
and hiring of financial personnel
• Damage assessments and computations in diverse
areas including family law, insurance claims, • Controller services
wrongful termination, personal injury, shareholder
disputes, breach of contract claims, lost profit
computations, and historical analyses
Abo And CompAny, llC
Certified Public Accountants — Litigation & Forensic Consultants
Plaza 1000 at Main Street, Suite 403 Voorhees, NJ 08043 • 856/489-5559 fax 856/489-5577 • www.aboandcompany.com
Bank of America Building, 6 E. Trenton Ave., Suite 5, Morrisville, PA 19067 • 215-736-3156 Fax 215-736-3215
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