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.
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