SC Lawyer, Sept. 2003, #8. Tax aspects of settlements & judgments.

• Author: By Brett A. Bluestein

South Carolina Lawyer

2003.

SC Lawyer, Sept. 2003, #8.

Tax aspects of settlements & judgments

South Carolina LawyerSeptember 2003Tax aspects of settlements & judgmentsBy Brett A. BluesteinDo attorneys need to be informed and up to date on the relevant case and statutory law regarding the various tax aspects of settlements and judgments? The answer is a resounding "yes" as evidenced by the old adage "a richer client is a better served client." From the inception of a potential lawsuit to its conclusion pursuant to a settlement or judgment, the attorney needs to be aware of the potential tax implications to the payor and the recipient of damages which can be dependent on a number of factors including how a complaint is structured to how damages are allocated among the various claims.

Tax effects of settlements/judgments to recipients

From a tax standpoint, the receipt of money or property pursuant to the resolution of a lawsuit is the same regardless if the resolution is in the form of a settlement or a judgment. See Longino Est. v. Comr., 32 T.C. 904 (1959) (settlement); Levens v. Comr., 10 T.C.M. 1083 (1951) (arbitration award). It is immaterial whether a settlement is reached before a judgment is rendered, after judgment but prior to the appeals process being exhausted or before a lawsuit is even filed.

Prior to the Small Business Job Protection Act of 1996, § 104(a)(2) of the Internal Revenue Code (the Code) provided an exclusion from gross income for recipients for damages received on account of both physical and non-physical personal injuries or sickness. Currently, § 104(a)(2) of the Code only provides for an exclusion from gross income for amounts received by recipients for physical personal injuries or sickness. The tax rationale behind this policy exclusion is that the receipt of such damages aims to make the recipient whole for the loss of physical or personal well being.

Physical personal injuries

In order to determine whether damages received by a recipient in a settlement or judgment are excluded from gross income, the origin and nature of the underlying claim must be examined. The origin and nature of the claim doctrine was initially set forth in Hort v. Comr., 313 U.S. 28 (1941) and subsequently clarified in U.S. v. Gilmore, 372 U.S. 39 (1963). The origin and nature of the claim doctrine was designed to restore the recipient to the same position tax- wise that he or she would have been in had the injury not occurred.

If the "origin" of the claim is a physical personal injury, then any recovery of damages are excluded from the gross income of the recipient pursuant to § 104(a)(2) of the Code. For example, a recovery on a claim for lost wages arising from an automobile accident, which is a physical personal injury, results in damages being excluded from the gross income of the recipient.

On the other hand, if the "origin" of the claim is a non-physical personal injury, then any recovery of damages are included in the gross income of the recipient. For example, a recovery on a claim for lost wages arising from an action under the age discrimination laws, which is a non-physical personal injury, results in damages being included in the gross income of the plaintiff.

Damages received pursuant to a judgment or settlement for personal injuries or sickness are excludable from gross income if the following two requirements are met: (1) there must be a physical personal injury or sickness and (2) damages must be received "on account of" such physical personal injury or sickness. Physical personal injuries include direct unwanted or uninvited physical contacts that results in observable bodily harm. See Priv. Ltr. Rul. 2000-41-022 (2000). In order for damages to be excluded from the gross income of the recipient, there must be a direct link between each element of the damages award and the physical personal injury or sickness. Receipt of damages for claims for non-physical personal injuries, such as, wrongful termination; age, race or sex based...