Allocations in personal injury settlements greatly affect tax treatment of proceeds.

• Author: Colton, Gary S.

Sec. 104(a)(2) excludes from gross income the amount of any damages received, whether by suit or settlement, for personal injuries or sickness, including libel, slander and defamation (which are considered personal injuries). Most lawsuits include a number of different claims. The plaintiff will ask for compensatory damages to cover the actual injury, lost wages, medical expenses and a host of other causes of action. Whenever possible, a claim for punitive damages will also be included. The amount of punitive damages stated in the suit will usually be a multiple of the actual damages claimed. Often, however, a jury will simply award one lump-sum amount for all damages. And while personal injury damages are excludible from gross income, punitive damages are excluded only if in connection with a case involving physical injury or physical sickness (Sec. 104). Most lawsuits are settled, many without any tax planning or no tax planning until the final settlement agreement is drafted. Proper tax planning from the earliest stages of the legal process can maximize the after-tax recovery for clients.

A settlement document will often contain language that the payments are being made exclusively for personal injury-type damages. It will state that no punitive damages are being paid, regardless of the amount alleged in the original suit. Labeling a breach of contract settlement as being exclusively for personal injury is not adversarial; the business defendant will be able to deduct the settlement payment regardless of its characterization. By settling with "after-tax dollars," can both sides come out ahead at the expense of the IRS?

Courts look to the "origin and character of the claim asserted" in deciding if a settlement payment falls under the Sec. 104 exclusion (Kurowski, TC Memo 1989-149). The "nature of the claim that was the actual basis for settlement rather than the validity of such claim" is the key (Downey, 97 TC 150 (1992)). To make this determination, the courts look at the pleadings, evidence introduced at trial, the settlement agreement and the intent of the payor. "In a given case, any one of these factors may be ultimately persuasive or ignored" (Threlkeld, 87 TC 1294 (1986)). The test boils down to the "facts and circumstances" and the burden of proof is on the petitioner (Seay, 58 TC 32(1972)).

In Knuckles, TC Memo 196433, the petitioner's attorney tried to turn a contract action into a personal injury action at settlement time by...