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Taxation of settlement awards

Posted by: Zaher Fallahi
Posted On: Dec 14, 2013

This IRS guide focuses on the treatment of lawsuit, settlements and awards proceeds received after August 21, 1996, the date of enactment of the Small Business Job Protection Act of 1996 (SBJPA) which revised IRC § 104(a)(2). Additional research may be warranted for issues involving proceeds received prior to August 21, 1996 or received under a written binding agreement, court decree, or mediation award in effect on (or issued on or before) September 13, 1995.

Because a business entity cannot suffer a personal injury within the meaning of IRC § 104(a) (2), P & X Markets, Inc. v. Commissioner, 106 T.C. 441 (1996), aff’d in unpublished order, P & X Markets, Inc. v. Commissioner, 139 F. 3d 907 (9th Cir. 1988), IRC § 104(a) (2) applies to recoveries byindividuals only.

IRC § 61 states all income from whatever source derived is taxable, unless specifically excluded by another Code section. IRC § 104 is the exclusion from taxable income provision with respect to lawsuits, settlements, and awards.

The 1996 amendment added to IRC § 104(a) (2) the word physical to the clause “on account of personal physical injuries or physical sickness.” Therefore, in order for damages to be excludible from income, the judgment or settlement must be derived from personal physical injuries or physical sickness. Prior to the 1996 amendment, IRC § 104(a) (2) was extensively litigated with respect to what was personal injuries.

In addition, the 1996 amendment added to the flush language of IRC § 104(a): “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 … attributable to emotional distress.” Thus, IRC § 104(a)(2) now provides that, in cases of non-physical injury, such as discrimination, fraud, etc., amounts excludable for emotional distress are limited to actual “out of pocket” medical costs. A footnote in the Conference Committee Report to the 1996 Act states that the term emotional distress includes physical symptoms, such as insomnia, headaches, and stomach disorders, which may result from emotional distress.

The 1996 amendment also clearly provides that punitive damages are not excludible under IRC § 104(a) (2), regardless of whether received in connection with a physical or non-physical injury. However, the 1996 amendment has raised the issue whether punitive damages received in connection with a wrongful death action are excludable from gross income.

In certain situations an amount of a lawsuit settlement might be paid to reimburse a taxpayer for losses, and no gain would have to be recognized under IRC § 1001 because the amount paid did not exceed the taxpayer’s basis (return of capital).

If you need assistance with your accounting, payroll processing, tax planning, preparation and the IRS representation including disclosure of your undeclared foreign bank accounts, please contact Los Angeles & Orange County CPA, Zaher Fallahi, at (310) 719-1040 (Los Angeles) or (714) 546-4272 (Orange County), or e-mail to [email protected].