Tax Planning

What You Don't Know May Hurt You

Given the prevalence of litigation and other legal settlements like worker’s compensation and similar settlements, now is a good time to go over income tax rules on litigation settlements.

The first rule you need to know is that, in general, payments received as compensation for personal injury or illness are not taxable. This includes the following type receipts:

Settlement for damages (other than punitive damages) occurring as a result of a physical injury;

Amounts received under workmen’s compensation acts as compensation for personal injury or sickness;

Amounts received through accident or health plans on account of personal injury or illness if they are reimbursements for medical expenses for which no deduction has previously been taken;

Amounts received as a pension, annuity or similar allowance for personal injury received as a result of service in the armed forces of any country;

Amounts paid as disability annuity due under section 808 of the Foreign Service Act of 1980;

Amounts received by an individual as disability income attributable to terrorist or military action.

There are certain eligibility requirements that must be met for individuals to be eligible for the exclusion of disability income for items 4, 5 and 6.

What does all of this mean? Basically, it means that your settlement has to be for actual physical injury or illness for you to exclude it from income. Specifically excluded from the definition of physical injury or illness is “mental pain and suffering.” Also, if the jury decides they wish to award punitive damages to “punish” the defendant, those damages are taxable income.

One of the best examples today of punitive damages that are likely includible in income are the many tobacco settlements. While there is no doubt a portion of those proceeds are for personal injury, it is reasonable to expect a large portion of a $4 billion settlement to one individual will be punitive in nature.

Similarly, payments that are primarily replacement of compensation are taxable income. For example, assume you work for a company that provides third party sick benefits or pays for all of your short-term and long-term disability insurance. If you are injured or sick and you receive third party benefits paid for by your employer, the income is taxable.

Age and sex discrimination settlements where no physical injury is alleged will result in taxable income.

So, what’s your best bet if you are involved in litigation that includes physical injury or illness? If the settlement is likely to include a personal injury component and a punitive or other component, have your attorney do his level best to include as much as is reasonable in the personal injury category. What the IRS is concerned with is the economic reality. If the case was really a discrimination case or lost wages case, it’s unlikely that calling the damages “personal injury” damages will fly with the Tax Court.

Have you received payments this year on account of personal injury or sickness that you think may be tax-exempt? Are you in the process of negotiating a settlement that could possibly include payments for personal injury or sickness? If either of these is true, give us a call. Let’s discuss the effect on your tax picture if you can negotiate a reasonable settlement for personal injury or if you are concerned about making the right estimated payments. In either case, we have the expertise to help you keep the maximum amount in your pocket.

For More Information Contact:

Bucheri McCarty & Metz LLP
2366 W. Boulevard
P.O. Box 2147
Kokomo, IN 46904-2147

Telephone: (765) 236-2300
FAX: (765) 236-2333
Internet: info@bmmcpas.com