The verdict is in and you received an award or settlement....Is it taxable?
Awards and settlements can be divided into two distinct groups. One group includes claims arising from a physical injury and the other group includes those arising from a non-physical injury. The claims from each of the two groups will usually fall into three categories:
1. Actual damages resulting from the physical or non-physical injury;
2. Emotional distress damages arising from the actual physical or non-physical injury; and
3. Punitive damages
Physical Injury or Sickness Physical
Prior to August 21, 1996, IRC § 104(a)(2) did not contain the word “physical” with regard to personal injuries or sickness. Consequently, many taxpayers were allowed to exclude from income amounts received on account of personal non-physical injuries and sickness while others erroneously failed to report as income almost all types of awards/settlements under IRC § 104(a)(2).
In 1996, IRC § 104(a)(2) was amended to exclude from gross income “the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.” IRC § 104(a)(2). However, the limitation to personal physical injuries or physical sickness contained in the 1996 amendment does not apply to any amounts received under a written binding agreement, court decree, or mediation award in effect on (or issued on or before) September 13, 1995. Pub. L. 104-188, Title I, Sec. 1605(a).
The Service has consistently held that compensatory damages, including lost wages, received on account of a personal physical injury are excludable from gross income with the exception of punitive damages.
Non-Physical Injury or Sickness
Prior to the amendment of August 20, 1996, the Service and the courts consistently interpreted IRC § 104(a)(2) as providing an exclusion for damages received in connection with claims of mental and emotional distress which arose from non-physical injuries. Examples of these type cases are employment wrongful discharge, discrimination, libel, etc. Please refer to Chapter 3 section on payroll and self-employment tax considerations for a discussion on FICA, FUTA, RRTA and SECA on back pay, lost wages, lost profits, etc. received in a lawsuit award or settlement.
The August 20, 1996, amendment has plainly resolved this issue on the side of the Government. With the exception of amounts paid to treat emotional distress, damages received after August 20, 1996, are excludable under IRC § 104(a)(2) only if received on account of physical injury or physical sickness. Therefore, a taxpayer receiving lawsuit proceeds from a non-physical injury claim cannot exclude any amount for payment to compensate for an intangible emotional distress value. The taxpayer can only exclude an amount for actual out of pocket medical costs. This exclusion would further depend upon whether the taxpayer had previously deducted those medical expenses on his or her tax return. See IRC §§ 111 and 213.
As discussed above under Physical Injury or Sickness, to be excludible, an emotional distress recovery must be on account of (attributed to) personal physical injuries or sickness unless the amount is for reimbursement of actual medical expenses related to emotional distress that was not previously deducted under IRC § 213. The flush language of IRC § 104(a) states, “For purposes of paragraph (2), emotional distress shall not be treated as a physical injury or physical sickness. The preceding sentence shall not apply to an amount of damages not in excess of the amount paid for medical care (described in subparagraph (A) or (B) of section 213(d)(1)) attributable to emotional distress”. According to a footnote in the Conference Committee Report to the 1996 SBJPA, Public Law 104 -188, the term "emotional distress" includes physical symptoms, such as insomnia, headaches, and stomach disorders, which may result from such emotional distress.
In Emerson v. Comr., T.C. Memo 2003-82, the Tax Court found that a tort recovery for various claims, including emotional distress, was not excludible under IRC § 104(a)(2) because the recovery was not received on account of personal physical injuries or physical sickness. Also, in Witcher v. Comr., T.C. Memo 2002-292, the Tax Court held that a tort recovery for various claims, including emotional distress and defamation, was not excludible because it was not received on account of personal physical injuries or physical sickness.
Punitive damages are not excludable from gross income under IRC § 104(a)(2).
With the enactment of SBJPA, Public Law 104 -188, Section 1605(a) in 1996, Congress made it clear in IRC § 104(a)(2) that punitive damages are taxable, regardless of the nature of the underlying claim.
IRC § 104(a)(2) states gross income does not include --
“the amount of any damages (other than punitive) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.” While IRC § 104(a)(2) clearly indicates punitive damages are taxable, IRC § 104(c) provides a limited exception to the treatment of punitive damages awarded in certain civil wrongful death cases. See section entitled “Wrongful Death” discussed below.
In cases settled outside of court that are on account of personal physical injuries or sickness, it is important to review the original claim documents to determine how much, if any, of the settlement amount is actually punitive damages. A reallocation may be needed.
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