Understanding the Tax Consequences of Tort Settlements and Awards

• Publication year: 2005
• Pages: 73

34 Colo.Law. 73 Colorado Bar Journal 2005.

2005, January, Pg. 73. Understanding the Tax Consequences of Tort Settlements and Awards

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73

Vol. 34, No. 1, Pg. 73

The Colorado Lawyer
January 2005
Vol. 34, No. 1 [Page 73]

Specialty Law Columns
The Civil Litigator
Understanding the Tax Consequences of Tort Settlements and Awards
by Jeffrey R. Bergstrom

The Civil Litigator column addresses issues of importance and interest to litigators and trial lawyers practicing in Colorado courts. The Civil Litigator is published six times a year

Column Editor

Richard L. Gabriel of Holme Roberts & Owen llp, Denver - (303) 861-7000, richard.gabriel@hro.com

About The Author

This month's article was written by Jeffrey R. Bergstrom, Denver, a shareholder of Darling, Bergstrom & Milligan, PC specializing in real estate, business, and income taxation - (303) 623-9133, jbergstrom@dbm-law.com.

This article addresses the significant tax consequences of litigation settlements and damages awards in tort cases. It is intended to assist counsel in advising clients as to the true net results of such settlements or awards.

Awards and settlements for tort claims usually can be divided into two distinct groups. The first group comprises claims that arise from physical injuries; the second consists of claims arising from non-physical injuries. Regardless of the major group into which it falls, the resulting damages usually will be classified into one or more sub-categories: (1) actual damages; (2) emotional distress damages; and (3) punitive damages.

The tax consequences of each of these groupings may differ; therefore, each separate claim should be carefully categorized. Once the categories of the claim have been properly determined, the attorney should advise the client as to the net result of the settlement. This figure is of ultimate importance, because it is used to determine the amount of taxable income.

This article reviews the general rules that help determine whether the results of a lawsuit or settlement will be taxable to the recipient. It also analyzes taxability issues in the context of a typical scenario.

Overview of Tax
Consequences

An analysis of the tax consequences of a tort claim starts with two general rules of the Internal Revenue Code ("IRC" or "Code"). First, IRC § 61(a) broadly provides that all income, from whatever source derived, is included in a taxpayer's gross income, except if otherwise provided in the Code.1

Second, IRC § 104(a)(2) generally excludes certain amounts from gross income. The most common exclusions are for:

Amounts received under workers' compensation

Damages, other than punitive damages, received in a lawsuit or settlement of a claim on account of personal physical injuries or physical sickness

Amounts received through accident or health insurance for personal injuries or sickness, except for certain amounts that are attributable to employer contributions or paid directly by the employer.

Despite the seemingly simple language of IRC § 104(a)(2), that statute probably has been one of the most litigated subsections of the Code. Historically, the issue usually centered on determining whether something was a personal injury. In other words, the issue was whether the claim encompassed physical or non-physical (mental distress) injuries and sickness, as well as whether any punitive damages received were on account of personal injuries.

Consideration of Capital Gains Versus Ordinary Income

Even if an award is included in the recipient's gross income, it might be characterized as capital gain rather than ordinary income. This distinction is important because each has different tax rates. Similar to the analysis of taxable versus non-taxable awards, it is necessary to look at the nature of the underlying claim to make this determination. For example, if a payment is meant to replace lost profits, the award is treated as ordinary income. However, if the payment is to redress an injury to a capital asset, the amount should be treated as capital gain.

Physical Injury or Sickness Awards Nontaxable

Prior to the Small Business Job Protection Act of 1996 ("SBJPA"),2 the definition of "personal injury" was arguably broad, as there did not need to be any sort of physical manifestation of the injury. For example, payments to settle a claim for "damage to reputation" possibly could have been excludable from income. That is no longer the case. IRC § 104(a)(2) was amended by the SBJPA in 1996 to clarify that damages received on account of a non-physical injury - for example, for age discrimination or injury to reputation - are not excludable from gross income.

Thus, IRC § 104(a)(2) is now applicable only to damages "on account of personal physical injuries or physical sickness."3 (Emphasis added.) For the straightforward physical injury claim, there is not much to debate. The amount received in settlement of such a claim will be non-taxable.

Although it might be logical to assume that the taxability of a non-physical claim would be equally clear, that is not the case. The amendment to IRC § 104(a)(2) has done little to curtail taxpayers from continuing to test the boundaries of what types of payments are excludable from income under that provision.

Taxability of Non-Physical Injury or Sickness

In an effort to provide some guidance as to claims of exclusion that have been tried without success, and in the tradition of the Tax Code, it is easier to describe what is not excluded by IRC § 104(a)(2) than to describe what is excluded. Except where exceptions apply, as described below, the following types of claims generally are not covered by the exclusion. Consequently, the amount received as either an award or settlement of such claims is taxable for: (1) emotional distress claims; (2) discrimination claims; (3) property damage or casualty loss claims; (4) lost earnings or lost compensation claims; and (5) corporate claims.

Emotional Distress Claims

Emotional distress itself is not a physical injury or physical sickness; therefore, amounts received to settle such a claim would be taxable.4 However, the amount paid for the medical care attributable to emotional distress that arose as a result of a physical injury or physical sickness would be...