by Thomas D. Begley, Jr., Esquire, CELA
Generally, “all income from whatever source derived” is considered gross income by the Internal Revenue Service (“IRS”). However, income received as a result of a personal physical injury or a physical sickness is not considered income by the IRS. However, punitive damages are considered taxable income.
Origin of the Claims Test
The determining factor with respect to the treatment of litigation recoveries is the “origin of the claim” test. “The origin and character of the claim upon which an expense was incurred rather than the potential consequence upon the fortunes of the taxpayer” is the controlling test. Generally, a claim for physical injuries or sickness qualifies for an exclusion. Cases may arise that are a mixture of physical injury and emotional distress. The treatment of claims in that situation will depend on the origin of the underlying claim. The IRS is not bound by an allocation in the release or even the court order. It is important that the parties substantiate the origin of the claim for tax purposes. Factors to be determined in determining the origin of the claim include:
- Allegations in the complaint;
- The legal issues involved;
- The nature and objectives of the litigation ;
- The defense as asserted;
- The purposes for which amounts claimed as deductible were expended; and
- The background of the litigation and all facts pertaining to the case or controversy.
The burden of proof is on the recovering party to demonstrate what portion of a recovery is taxable and what is non-taxable.
The physical injury generally involves a touching that produces physical harm. The physical harm must be observable bodily harm. Therefore, it would appear that most settlements involving sexual abuse victims are subject to taxation, because there is seldom observable bodily harm. Emotional distress is not treated as a physical injury or physical sickness. However, damages for emotional distress would be excludable from income, unless they flowed from a related physical injury. However, in a Worker’s Comp claim, personal injuries are sufficient. Physical injuries are not required, because they are not tort-based claims.
In certain cases, such as wrongful death cases, the proceeds paid in connection with the wrongful death claim are excluded from income, even for parties who suffer a non-physical injury because the wrongful death victim did suffer a physical injury. The derivative claims are entitled to the same income tax exclusion, because the origin of the claim is the underlying physical injury to the decedent. The survival claim is excluded from income, because of the physical injury to the decedent; however, the survival claim is included in federal and New Jersey estate tax and New Jersey inheritance tax. Disability insurance payments are taxable if the premiums for the disability insurance were paid by the employer, but are excluded from tax if the premiums were paid by the employee. Generally, payments for defamation are taxable income, unless there is a physical injury or physical sickness from which the defamation flowed.
Once the claim results in a settlement or award, the value is clear. However, as of the date of the decedent’s death, it is not certain whether there will be a recovery or, if so, how much. For taxation purposes, what is the value of the claim as of the death of the decedent? For estate tax purposes, the date of death value controls. The value of a claim as of the decedent’s death will depend, to a certain extent, on the stage at which the lawsuit was as of the date of death. An opinion of an accountant or another personal injury attorney concerning the likelihood of bringing the decedent’s suit to judgment or settlement as of the time of the decedent’s death can be persuasive. The Tax Court has dealt with this issue. The Davis court approved certain factors to be taken into account in reducing valuation, including but not being limited to, costs of litigation, hazards of litigation, and the time delay in receiving funds. An expert report might include the basis of the claim, nature of defenses, the prospects for obtaining a judgment based on the factors in existence at the time of death, and the nature and extent of discovery.
Under common law, defamation is a traditional tort. However, any recovery for defamation is taxable income, unless there is a physical injury or physical sickness from which the defamation flowed.
Confidentiality agreements may be taxable income. The issue arises out of the United States Tax Court case Avis v. Commissioner. Dennis Rodman, a basketball player for the Chicago Bulls, kicked a photographer. The photographer brought suit, which settled for $200,000. The release stated that part of the consideration was that terms of the agreement and release be kept confidential. The release also contained a liquidated damage clause to the effect that if there was a material breach of the confidentiality agreement, Rodman would be entitled to $200,000. The court held that the dominant reason for the settlement was because of the plaintiff’s physical injuries, but there was a separate payment for the confidentiality clause. The court allocated $120,000 of the settlement for the physical injuries and $80,000 for the confidentiality agreement. The $80,000 allocated to the confidentiality agreement was taxable.
One solution to avoid the tax is to include reciprocal promises of confidentiality in the release without additional consideration.
 I.R.C. §61.
 I.R.C. §104.
 I.R.C. §104, O’Gilvie v. United States, 519 U.S.C. 79 (1996).
 The United States v. Gilmore, 83 S. Ct. 623 (1963).
 I.R.C. §104(a)(2).
 I.R.C. §104(a)(2).
 Boagni v. Commissioner, 59 T.C. 708 (1973).
 Sager Glove, Corp. v. Commissioner, 311 F.2d 210 (7th Cir. 1962).
 P.L.R. 20041022.
 I.R.C. §104(a)(5).
 I.R.C. §104(a)(1).
 Anderson v. Commission, T.C. Memo 2003-168 aff’d 194 Fed. App.’s 47 (9th Cir. 2004).
 Davis v. CIR, TCM (CCH), 2365 (1993).
 Henderson v. Commissioner, T.C. Memo 2003-168, aff’d, 104 Fed. App’x. 47 (9th Cir. 2004).
 T.C. Memo 2003-329 (Dec. 1, 2003).