Friday, October 26, 2012

Compensatory Damages Tax Exclusions Section 104

What types of damages from a personal injury lawsuit are excluded from income?

§ 104(a)(2) excludes from gross income “any damages (other than punitive damages) received (by suit or agreement/lump sums or as periodic payments) on account of personal physical injuries or physical sickness.”

Requirements of §104(a)(2)

Taxpayer must demonstrate that the underlying cause of action giving rise to a recovery is based upon tort or tort types of rights. And, the taxpayer must show that the damages were received “on accounting of personal injuries or sickness”

The determination of the nature of the claim is factual. Where there is a settlement agreement, that determination is usually made in reference to it. If the settlement agreement lacks express language stating what the amount paid pursuant to that agreement was to settle, the intent of the payor is critical to that determination. 

Nonpecuniary damages- Losing a body part is like selling it.  The IRC puts someone injured in the same tax position as if he had not been forced to realize the gain inherent to his arm.  The exclusion of nonpecuniary damages is based on special congressional solicitude for victims of forced sales.  Body part has zero basis. Permanent exclusion not conditioned on the taxpayer’s use of the damage award. § 1033 for forced sale is only deferral of taxes instead of exclusion. Maybe people should be giving deductions for losing an arm. This could create more overall equity to people with no tort recovery.

Medical Expenses: Exclusion of medical expense damages piggybacks on the §213 deduction for medical expenses. Normally, the medical expense deduction is allowed only for expenses in excess of 7.5% of the taxpayer’s gross income. No limitations to medical damages excluded under § 104(a)(2)

Lost Wages: Hardest part of §104(a)(2) to justify. Why should the tort equivalent of what someone would normally earn be excluded? Hard to allocate a lump sum. Maybe the money normally taxed would go to attorney? Most juries are not informed that the award is tax free. Only from when you physically cannot work. The exclusion for lost wages is sometimes explained as a tax subsidy for the tort plaintiff’s contingent attorney’s fees

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