Are Insurance Bad Faith Recoveries Taxable?
| Publication year | 2016 |
| Author | Robert W. Wood |
Robert W. Wood
Robert W. Wood is a tax lawyer with www.WoodLLP.com, and the author of numerous tax books, including Taxation of Damage Awards & Settlement Payments (www.TaxInstitute.com). This discussion is not intended as legal advice.
Are insurance bad faith litigation recoveries taxable? The annoying answer is: it depends. This is because, although damage awards and insurance proceeds are generally considered "gross income" for tax purposes, the Internal Revenue Code ("IRC") provides an exception for damages received "on account of personal physical injuries or physical sickness" and for amounts received "through accident or health insurance ... for personal injuries or sickness."1 As discussed in this article, determining whether a particular bad faith recovery qualifies under one of these exceptions can be tricky.
It may be helpful to begin with a brief description of what a bad faith claim may entail. Such a claim may be a tort or a contract claim, depending on the facts and the jurisdiction. It may be brought against one's own insurance carrier or against another party's carrier.
Not surprisingly, most bad faith insurance cases relate to the mishandling of insurance claims. A common claim is that the insurance company defendant did not proceed appropriately to pay a claim, thus causing the plaintiff additional damages. Consider, for example, a physical injury accident where the insurance company pays too little too late, and later must pay more for the same injuries via a bad faith claim. This is a useful (and common) example to bear in mind.
Not unlike a legal malpractice claim against a lawyer, one key question will predate the bad faith case for tax purposes: what was the underlying issue (which may or may not have been litigated) that gave rise to the insurance claim?
In bad faith insurance cases, there is an underlying cause of action for which the plaintiff is seeking redress. It might be a personal physical injury action or something else. The bad faith claim may be viewed as a contract claim relating to the insurance policy, or as a tort claim related to an insurance company's operations and its treatment of the plaintiff.
The Internal Revenue Service ("IRS") has generally viewed bad faith claims as contract actions. Nevertheless, as discussed below, it is relevant to inquire into the treatment of damages that, at least in part, often relate to the original act producing the underlying insurance claim.
It is a well-worn axiom that almost everything is taxable. The IRC bears this out, stating in § 61 that, except for express and explicit exclusions, everything is gross income.2 That applies to lawsuit recoveries, whether by settlement or judgment.3
This applies to insurance recoveries, too. Fortunately, though, there is an explicit statutory exclusion in section 104 of the IRC for recoveries for personal physical injuries or physical sickness.4 It does not apply to punitive damages.
There has been great controversy over what the word "physical" means in this context. § 1.104-1(c) of the Income Tax Regulations defines the term "damages received (whether by suit or agreement)" as an amount received (other than workmen's compensation) through prosecution of a legal suit or action based upon tort or tort-type rights, or through a settlement agreement entered into in lieu of such prosecution."
One of the most important authorities with respect to the tax status of bad faith recoveries is an IRS private letter ruling issued in 2009 ("2009 Letter Ruling").5 It was a bombshell ruling when issued, and it suggests that some bad faith recoveries are tax-free. Relevant case law, on the other hand, suggests that some taxpayers may be reading the ruling too broadly.
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In 2009 Letter Ruling,6 a plaintiff had been employed as a construction worker, and in the course of his employment, was struck by a drunk driver. The drunk driver managed a tavern, and had served himself liberally while on duty. The plaintiff was severely injured, and sued the driver, as well as the tavern that had employed him.
The plaintiff received a jury verdict consisting of compensatory damages for his personal physical injuries, medical expenses, pain and suffering, and lost earnings, plus punitive damages. After post-trial motions, the jury verdict was reduced as to both the compensatory damages and punitive damages. The defendants appealed.
Prior to the judgment, the insurer for the tavern had rejected an opportunity to settle for policy limits under the tavern's policy. Under state law, the tavern, as policy holder, had a cause of action against the insurance company if it acted in bad faith in failing to settle the claim. The tavern believed it had a cause of action against the insurance company.
As part of an agreement to stay the execution of the plaintiff's judgment, the tavern assigned to the plaintiff its rights to pursue a bad faith claim against the insurance company. The agreement between the tavern and the plaintiff...
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