INCOME TAXATION IN PERSONAL INJURY CASES

by Thomas D. Begley, Jr., Esquire, CELA

 

Generally, personal injury damages are excludable from taxation.[1] The Code deals with compensation for injuries and sickness and states, “[i]n general, gross income does not include the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or periodic payments) on account of personal physical injuries or physical sickness.” This exclusion is broad enough to cover damages received from personal injury litigation including portions of a recovery that might be intended to replace lost income, which would otherwise be taxable if received outside of a settlement or award.

Some interesting examples are as follows:

• Physical Injuries. As a general rule, if a claim is for physical injuries or sickness the recovery will qualify for an exclusion under I.R.C. 104(a)(2).
• Emotional Distress.
  • General. The Code specifically states that “emotional distress shall not be treated as a physical injury or physical sickness.”[2] Emotional distress might include such symptoms as insomnia, headaches, stomach disorders, etc. However, damages for emotional distress would be excludable if they flowed from a related physical injury.

The exclusion under § 104 covers damages arising from tort or tort-like claims, as well as Workers’ Compensation claims. In a Workers’ Compensation claim, personal injuries are sufficient. Physical injuries are not required[3] as they are in tort-based claims.[4]

• Non-Taxable Emotional Distress Damages. However, emotional distress damages are non-taxable under certain circumstances:[5]

• The claimant’s emotional distress resulted from the claimant’s physical injuries or physical sickness; or
• The claimant’s emotional distress resulted from another person’s physical injury or physical sickness; or
• The damages compensate the claimant for expected medical expenses; or
• The emotional distress was so significant that it caused physical ailments observable by a doctor, i.e., a heart attack.
  • Stress-Induced Physical Ailments. What about a situation where a plaintiff suffers emotional distress that induces physical ailments? The tax court has indicated that recovery may be tax free where (1) the taxpayer can demonstrate that the damages were actually received on account of those ailments, and (2) the physical nature of the ailments was verified by a physician, preferably based on objective medical evidence rather than the taxpayer’s subjective report of symptoms.[6]
• Legal Malpractice. An interesting issue arises in cases where a personal injury attorney representing a client who suffered physical injuries is guilty of malpractice such as for failing to file within the statute of limitations or failing to present proper evidence, etc. If the plaintiff sues the personal injury attorney in a malpractice action and recovers, is the settlement or award taxable to the plaintiff? While there are so far no cases on this issue, it would seem that the rationale applying to the bad faith claim above would apply.
• Bad Faith Claim. In a Private Letter Ruling,[7] the IRS held that where there was an underlying claim for a physical injury and the insurance company refused to pay, the recovery from the bad faith claim against the insurance company was non-taxable because the origin of the claim was physical damages to the plaintiff.
• Medical Deductions. If the taxpayer has taken a medical deduction in one year and receives a personal injury settlement, the settlement is taxable to the extent of the prior medical deduction but the excess over the prior deduction is tax free.[8] If the client has previously deducted medical expenses and they are now considering a settlement, it is best to allocate a smaller, though reasonable, portion of the settlement to past medical expenses.

[1] I.R.C. § 104(a)(2).

[2] I.R.C. § 104(a)(5).

[3] I.R.C. § 104(a)(1).

[4] I.R.C. § 104(a)(2).

[5] Parkinson v. Commissioner, T.C. Memo 2010-142.

[6] Blackwood v. Commissioner, T.C. Memo 2012-190

[7] Priv. Ltr. Rul. 200903073.

[8] I.R.C. § 104(a).