Taxation of Settlements and Court Judgments

Overview      

Farming and ranching, while it can provide a rewarding way of life for those involved, is a very dangerous occupation.  Working with or around machinery and equipment, hazardous chemicals and pesticides, livestock, water, and projects that involve electricity are just some of the activities that can lead to injury or death.   Sometimes, legal recourse is sought and that can lead to a court judgment or a settlement.

How is a monetary court award or settlement taxed?  It’s an important question, particularly when the amount of the award or settlement is large.  A recent IRS private ruling illustrates how the taxation of court awards and settlements are taxed.

The taxation of monetary court awards or settlements – it’s the topic of today’s post.

The Basics

Generally, the courts use a fact based “origin of the claim” test to determine the tax character of court awards and settlement funds. See, e.g., French v. Comr., T.C. Sum. Op. 2018-36.  Under the test, any funds the taxpayer receives are deemed to be a substituted payment for the damages that the taxpayer was alleging.  As a result, an amount recovered will be determined either to be taxable or not subject to tax, with causality the key to the determination.  See, e.g., Lindsey v. Comr., 422 F.3d 684 (8th Cir. 2005).  Often, that causality is tied to extrinsic factors such as the details of the litigation, allegations contained in the complaint, and how the settlement negotiations were proceeding. 

The “origin of the claim” test also determines the character of any taxable amount as either ordinary income or capital gain. 

Physical injury or sickness.  Recoveries from out-of-court settlements or as a result of judgments obtained may fall into any one of several categories. Quite clearly, damages received on account of personal physical injury or physical sickness are excluded from income.  I.R.C. §104(a)(2).  Amounts received on account of mental distress may be received tax-free if the distress is directly related to personal injury. See, e.g., Barnes v. Comm’r, T.C. Memo. 1997-25. As the regulations point out, nontaxable damages include “an amount received (other than workmen's compensation) through prosecution of a legal suit or action based on tort or tort-type rights, or through a settlement agreement entered into in lieu of such prosecution.”  Treas. Reg. § 1.104-1.

Punitive damages.  Legislation enacted in 1996 specifies that recoveries representing punitive damages are taxable as ordinary income regardless of whether they are received on account of personal injury or sickness. Small Business Job Protection Act of 1996, P.L. 104-188, Sec. 1605(a); See, e.g., O'Gilvie v. United States, 519 U.S. 79 (1996). 

Lost profit.  The 1996 enactment also made it clear that damages not attributable to physical injury or physical sickness are includible in gross income.  In many lawsuits, there is almost always some lost profit involved and recovery for lost profit is ordinary income.  See, e.g., Simko v. Comm’r, T.C. Memo. 1997-9.  For recoveries in connection with a business, if the taxpayer can prove that the damages received were for injury to capital, no income results except to the extent the damages exceed the income tax basis of the capital asset involved.  The recovery is, in general, a taxable event except to the extent the amount recovered represents a return of basis.  Recoveries representing a reimbursement for lost profit are taxable as ordinary income.

Legal Challenge

In 2006, the U.S. Circuit Court of Appeals for the District of Columbia ruled that the distinction drawn in the 1996 amendment was unconstitutional. Murphy v. United States, 460 F.3d 79 (D.C. Cir. 2006). In the case, the plaintiff sued her former employer and was awarded $70,000 ($45,000 for mental pain and anguish and $25,000 for “injury to professional reputation”).  The plaintiff originally reported the entire $70,000 as taxable and then filed amended returns excluding the income.  The IRS maintained that the entire $70,000 was taxable, and the trial court agreed.  On appeal, the court held that the $70,000 was not excludible from income under the statute, but that I.R.C. §104(a)(2) was unconstitutional under the Sixteenth Amendment since the entire award was unrelated to lost wages or earnings, but were, instead, payments for the restoration of the taxpayer’s human capital.  Thus, the entire $70,000 was excludible from income. However, in late 2006, the court vacated its opinion and set the case for rehearing.  Upon rehearing, the court reversed itself and held that even if the taxpayer’s award was not “income” within the meaning of the Sixteenth Amendment, it is within the reach of the power of the Congress to tax under Article I, Section 8 of the Constitution.  In addition, the court reasoned that the taxpayer’s award was similar to an involuntary conversion of assets – the taxpayer was forced to surrender some part of her mental health and reputation in return for monetary damages.”  The U.S. Supreme Court declined to hear the case.  Murphy v. Internal Revenue Service, 493 F.3d 170 (D.C. Cir. 2007), reh’g. den., 2007 U.S. App. LEXIS 22173 (D.C. Cir. Sept. 14, 2007), cert. den., 553 U.S. 1004 (2008).

IRS Private Ruling

In Private Letter Ruling 202050009 (Sept. 10, 2020), the taxpayer was riding his bicycle on his way home from work when he was hit by an automobile.  He was severely and permanently injured, including sustaining a traumatic brain injury resulting in his cognitive impairment.  The taxpayer sued the company that employed the driver that hit him.  The complaint alleged damages on account of the defendant’s negligence, recklessness and the driver’s willful and wanton acts.  Damages were sought for the taxpayer’s medical bills; mental anguish; loss of enjoyment of life; disability; pain and suffering; and other injuries and damages, including loss of consortium for the taxpayer’s wife.  

The trial court jury found the defendant liable and awarded the taxpayer (and spouse) damages for past and future economic damages (medical bills) and for past and future non-economic damages (mental anguish).  The jury also awarded the taxpayer’s wife damages for past and future loss of consortium.

The IRS determined that the taxpayer’s damages were not taxable because the awarded damages were tied to the taxpayer’s physical injuries sustained as a result of the bicycle accident.   

Attorney Fees

As a side-note, if the amount of an award or court settlement includes contingent attorney fees, the portion of the award representing contingent attorney fees is includible in the taxpayer’s gross income.  Comm’r, v. Banks, 543 U.S. 426 (2005), rev’g and rem’g sub. nom., Banks v. Commr, 345 F.3d 373 (6th Cir. 2003).

For fees and costs paid after October 22, 2004, with respect to a judgment or settlement occurring after that date, legislation enacted in 2004 provides for a deduction of attorney’s fees and other costs associated with discrimination in employment or enforcement of civil rights.  I.R.C. § 62(a)(20).

Conclusion

Most legal actions brought by farmers or ranchers against others as a result of business transactions or tort-type injuries often involve an element of lost profit and some involve recovery of basis.  Therefore, there is likely to be at least a partially taxable event.  The proper characterization of recoveries is vitally important.  In addition, there may be a discharge of indebtedness involved and, in some instances, the transaction may be characterized as a “sale” of property to a creditor.

And a very Merry Christmas to all!