The Impact of Taxes on Damage Awards and Settlements
| Publication year | 1990 |
| Pages | 2453 |
1990, December, Pg. 2453. The Impact of Taxes on Damage Awards and Settlements
This article discusses how taxes affect damage awards and settlements. It is divided into two categories: personal injury/wrongful death and commercial litigation. The taxation of plaintiffs on damage awards and corresponding deductions of defendants are considered, together with whether taxes should be accounted for in the calculation of damages.
Personal injury and wrongful death damage awards or settlement sums generally are not taxable as income. The general rule regarding the taxation of damage awards in personal injury cases is set out in § 104(a)(2) of the Internal Revenue Code of 1986, as amended ("Code"), which reads as follows:
[G]ross income does not include the amount of any damages received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injuries or sickness.
The Code § 104 exclusion extends to sums received as a result of wrongful death actions.(fn1) Congress amended this exclusion in 1989 to limit its availability to actual damages by providing that the exclusion from income no longer applies to punitive damages in cases not involving physical injury or sickness.(fn2) Previously, courts had, on occasion, extended the personal injury award exclusion to punitive and other consequential personal damages, even where the underlying cause of action was not personal in nature.
However, as noted in a recent Colorado Court of Appeals decision, the portion of a personal injury award allocable to medical expenses previously paid and deducted is included in taxable income.(fn3) Therefore, a practitioner must scrutinize carefully any personal injury damage award before assuming it is not taxable in whole.
Courts have not been consistent in their interpretation of the scope of Code § 104. In Roemer v. Commissioner,(fn4) the Tax Court considered the business (loss of income) as opposed to the personal nature of the injuries in concluding that an award was taxable. In reversing the Tax Court in Roemer, the Ninth Circuit ruled that damages for injury to personal reputation are excluded from income under Code § 104, even if the damages are manifested in nonphysical losses, such as to income and to business or professional reputation.(fn5)
Following the Ninth Circuit's decision in Roemer, the Tax Court ruled that an action for malicious prosecution would be classified as personal injury under Tennessee law. It further ruled that, under the "origin of the claim" test, all resulting damages, including damages to professional and business reputation, are excluded from gross income under Code § 104(a)(2).,(fn6)
A further case of interest involved damages paid to a high school teacher by a local board of education for violating the teacher's freedom of speech.(fn7) In this case, the Tax Court held that the damages were not included in gross income under the terms of Code § 104(a)(2), and the Third Circuit affirmed. The entire out-of-court settlement was excluded, despite the fact that lost wages had been taken into account in settlement negotiations.
When considering whether taxes are payable on damage awards in commercial litigation, the question in each case is what the damages are in lieu of.(fn8) The general rule is that damages which represent a reimbursement for lost profits are taxable as ordinary income.(fn9)
However, if the taxpayer is able to show that the damages received are for loss or damage to capital assets, no income results except to the extent that the
It is apparent that the nature of the damage award determines whether it is included in or...
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