Midnight surprise - personal injury alert.

• Author: Singer, Robert M.

In the Small Business Job Protection Act of 1996, Congress severely limited the income exclusion of damages received on account of personal injury. The law was passed by Congress with several restrictions that were in the House Bill, but not die Senate Bill. The exclusion generally applies to amounts received after Sept. 13, 1995.

All Punitive Damages Taxable

First, whatever contrary argument there was prior to this bill, all punitive damages are taxable, except in a wrongful death action when only punitive damages may be awarded. It does not matter the type of case, i.e., whether it relates to personal injury, or whether there are physical injuries or nonphysical injuries. (See O'Gilvie, 66 F3d 1550 (10th Cir. 1995), on the taxability of punitive damages in cases of personal physical injury. When the Supreme Court decides this case, its decision will not apply to punitive damages received after the date of enactment of the law.)

Damages Excluded From Income

Only for Compensation of

Personal Physical Injury

Compensatory damages are exempt from tax only when awarded for (1) personal injury or (2) physical injury or sickness. These are two separate and distinct requirements.

The first requirement - for personal injury - is murkier than ever. Under prior law, the courts and the IRS evaluated whether the damages were personal, as compared to business or professional. There was an additional requirement that the injury be from a tort or tort-like action. Presumably, these two requirements are still in place.

The second requirement is not clearly defined either in the law or the committee report. However, following the Supreme Courts decision in Schleier, 115 Sup. Ct. 2159 (1995), physical injuries are likely to be defined as injuries of the body or mind. Physical injuries must be distinguished from injury with no harm to the body, as in cases of defamation or discrimination or a wrongful discharge claim with an accompanying claim for defamation. Therefore, one must separate injuries to the person/body, as compared to economic interests.

Damages Flowing From Physical

Injury or Sickness

The more interesting issues relate to claims based on a personal physical injury along with pain and suffering, as well as other claims for such items as discrimination and loss of wages (physical and nonphysical injuries). The committee report specifically provides for the exclusion of all damages that flow from a personal physical injury, whether or not the...