Tax Consequences of Damages
| Publication year | 1983 |
| Pages | 53 |
| Citation | Vol. 12 No. 1 Pg. 53 |
1983, January, Pg. 53. Tax Consequences of Damages
This article discusses the federal income tax consequences of damage awards or settlements. The inclusion in gross income of damage payments generally depends on the origin and character of the claims adjudicated or settled and on the compensatory or punitive nature of the payments. Tax deductions for damage payments are generally dependent upon whether the payments constitute ordinary and necessary expenses paid or incurred in carrying on a trade or business. The payor's reasons for making the damage payment are usually immaterial in determining its tax consequences to the payor and payee.
IRC § 104(a)(2) excludes from gross income "the amount of any damages received (whether by suit or agreement) on account of personal injuries or sickness."(fn1) The exclusion applies to compensatory damages for medical expenses and lost earnings, past and prospective, as well as punitive damages.(fn2) It also applies to reimbursements for attorney's fees incurred in the litigation.(fn3) If the personal injury results in death or if the injured person dies before the end of the period during which damage payments were to be made, payments to the estate also qualify for the exclusion.(fn4)
If the damages are received as reimbursement for medical expenses previously paid, the reimbursement is taxable in the year of receipt to the extent of the medical expense deduction allowed in any prior taxable year. Unless the judgment or settlement contains an express allocation of damages to previously paid medical expenses, it is presumed that the recovery is attributable first to medical expenses previously deducted.(fn5)
The portion of a personal injury settlement specifically allocated to future medical expenses must be totally offset against the future medical expenses as they are paid before any such expenses are deductible under IRC § 213.(fn6) If the settlement does not make a specific allocation for future medical expenses, an allocation will be made on the best evidence available.(fn7)
IRC § 104(a)(2) also applies to amounts recovered for non-physical personal injuries such as pain and suffering.(fn8) In Seay v. Commissioner,(fn9) the Tax Court held that the portion of a settlement made for personal embarrassment, mental strain and injury to health and personal reputation was excludable under IRC § 104(a)(2). Compensatory damages for injury to personal reputation as a result of libel or slander are also excludable from income.(fn10) Damages for invasion of privacy are not includable in income unless received in advance for a waiver of the invasion.(fn11)
Under Rev. Rul. 58-418,(fn12) punitive damages recovered in connection with non-physical injuries are taxable. In that ruling, exemplary damages for injury to personal reputation were held to constitute taxable income. If both compensatory and punitive damages are recovered for injury to personal reputation and no allocation is made between such damages in the settlement or award, the recovery is to be prorated on the basis of the ratio of punitive damages to total damages requested in the complaint.(fn13)
If a lump-sum damage payment for personal injury is invested and the recipient has actual or constructive benefit of the lump-sum payment, none of the income from the investment is excludable under IRC § 104. Interest earned on a personal injury award is taxable.(fn14) If an annuity contract is purchased by the recipient of a lump-sum personal injury recovery, only the lump-sum payment is excludable.(fn15) However, if the payor purchases and retains exclusive ownership of a single premium annuity contract to fund monthly payments in settlement of a personal injury suit, the recipient is entitled to exclude the full...
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