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Tax Newsletter

Tax Effects of Personal Injury Award Allocations

The U.S. Internal Revenue Service (IRS) takes a broad view of what is considered “income” for purposes of taxation. The U.S. Supreme Court has provided additional interpretation, stating that “any funds” received by a taxpayer are presumed to be part of gross income. This may include money received as a result of a court award or settlement on a personal injury claim.

General Principles

A “tort” is a wrongful act that causes harm to another. The injuring party may be held liable for related damages and, in some instances, “punitive damages,” meant to punish the injuring party. Under applicable law and IRS Regulations “damages received” through prosecution of a legal suit or action based upon tort or tort-type rights, or through a settlement entered into in lieu of such prosecution, are generally taxable as income.

Luckily the law provides some important exemptions to this rule. Tort awards, and even settlements, may include different categories of damages and recovery for separate torts – some taxable, some not. Tax laws and regulations frequently change, but this article outlines general tax principles applicable to tort awards and settlements.

Damages for “Physical Injuries and Physical Sickness”

Under current federal law, damages received on account of personal “physical injury” and “physical sickness” are generally excluded from gross income. The law does not define these terms, but they clearly include most types of bodily harm, such as a broken leg. Complaints such as headaches, insomnia, and stomach disorders are not considered physical injuries. The exemption includes workers’ compensation awards that arise out of such injuries, but damages for claims such as wrongful discrimination are generally not exempt from taxation.

Damages for “Emotional Distress” and “Loss of Consortium”

“Infliction of emotional distress” is often added as a separate claim in a tort action. Recovery for actual medical fees and costs of treatment of emotional problems is not taxable as a rule. Damages recovered for emotional distress itself generally must be included in income, but damages for emotional distress arising out of physical injury or sickness may be excludable in income. Unfortunately, there is often no easy way to differentiate, so taxability may depend on the circumstances of each case.

“Loss of consortium” is the loss of the conjugal relationship between spouses, and includes companionship, affection and aid. Damages for loss of consortium are generally not taxable.

Punitive Damages

When the conduct of the person causing the injury is particularly reprehensible (i.e., done with the intent to harm, “wanton and willful,” or “in disregard for the welfare and safety of others”), courts may impose “punitive damages” to punish the wrongdoer. An amendment to the Internal Revenue Code by the “Small Business Job Protection Act of 1996” and a contemporaneous U.S. Supreme Court decision clarify that punitive damage awards are taxable, even if imposed in a tort action where there is physical injury or sickness. One exception to this rule is for punitive damages awarded in a wrongful death action. If applicable state laws limit the scope of an award for damages to punitive damages in connection to wrongful death claims, then such awards are not taxable.

Lost Wages and Interest

Lost wages are almost always taxable as income. Frequently the injured party will seek an award of interest on the amount recovered, calculated from the time the injury occurred and / or the time the court makes its judgment. Most courts have held that such interest is taxable, but there are courts that have held differently.

Attorneys’ Fees

In personal injury cases, injured parties and their attorneys often agree that the attorney will be paid a “contingency fee,” i.e., a percentage of any award or settlement. U.S. Tax Courts and the majority of federal courts have held if the award or settlement is taxable, then the contingent fee paid to the attorney is also includable as income of the injured party. However, courts in some federal jurisdictions have disagreed with this analysis; thus taxability may depend on where the taxpayer resides.

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