Taxpayers who suffer from physical injuries or physical sickness can generally take advantage of a special provision in the Code that makes such damages non-taxable.  See I.R.C. § 104(a)(2).  Generally, this can be an easy determination.  However, what happens if the taxpayer is engaged in a lawsuit and receives damages through a judgment or settlement?  How does the IRS know if those damages are subject to non-taxation under I.R.C. § 104(a)(2)?

Generally, federal courts and the IRS characterize judgment and settlement payments according to the “origin of the claim” test.  Under this test, any amounts received from a judgment or settlement will be characterized for federal income tax purpose as a substitute payment for the claims or damages the taxpayer asserted or incurred.  Significantly, the origin of the claim test is used to determine whether an amount is taxable or non-taxable and also, if taxable, whether such amount constitutes ordinary income or capital gain.  The origin of the claim test depends on the particular facts.

In many cases, taxpayers will enter into settlement agreements with respect to any injuries asserted prior to or during a lawsuit.  In these instances, the nature of the claim that was the basis for the settlement generally controls whether damages are excludible under I.R.C. § 104(a)(2).  Accordingly, the terms used in the settlement agreement can be significant in determining the origin and allocation of any settlement proceeds for federal tax purposes.  Federal tax attorneys can be invaluable in assisting taxpayers in the drafting of such settlement agreements.

In some cases, however, taxpayers do not enter into settlement agreements and proceed to trial, either by judge or jury.  For example, in PLR 2020500009, a taxpayer-husband was struck by an automobile while riding his bike home from work.  The taxpayer-husband suffered from severe and permanent injuries to his body, which included traumatic brain injuries.  As a result, the taxpayer-husband was in constant pain and suffered from cognitive impairment.  Moreover, taxpayer-husband’s wife also suffered significant loss of consortium due to taxpayer-husband’s injuries.

Taxpayer-husband and taxpayer-wife sued the company who employed the driver.  In the lawsuit, they alleged that the injuries and damages suffered were the result of acts of negligence, recklessness, and willful and wanton acts of the driver.  The lawsuit requested damages for economic injuries (medical bills), for non-economic injuries (mental anguish), loss of enjoyment of life, disability, pain, suffering, and other injuries and damages as well as damages for loss of consortium.

At trial, the jury found the company liable and awarded taxpayer-husband and taxpayer-wife damages for past and future economic damages and for past and future noneconomic damages.  The jury further awarded taxpayer-wife damages for past and future loss of consortium.

On these facts, the IRS held that the taxpayer-husband and taxpayer-wife were not subject to federal income tax on any damages awarded to them under I.R.C. § 104(a)(2).  Specifically, the IRS recognized that the past and future economic and noneconomic damages to taxpayer-husband and the loss of consortium damages to taxpayer-wife were directly attributable and linked to the physical injuries taxpayer-husband had received when the collision occurred.

For more insights, see A Primer On The Tax Implications Of Settlements And Judgements.

Have a question? Contact Matthew Roberts, Freeman Law, Texas.