Settlement Damages

Since the 1996 tax law change, one of the main areas of dispute between taxpayers and the Internal Revenue Service has been the allocation of “damage awards.” When you, the taxpayer, receive a settlement payment for damages, the tax consequences vary depending on the type of award received.

In order to determine the tax treatment, the taxpayer will need to allocate the settlement between punitive damages, loss of income, personal injury, etc. For example, if you are injured on the job and receive a nonworkers’ compensation settlement of $1 million dollars, the portion for punitive damages award is taxable to you but the amount for physical damages is not taxable. So, obviously the first question your tax adviser will ask you is how much the allocation is.

Previously (prior to 1996), the problem was whether the amount of the settlement damage was received for injury or sickness (Section 104(a)(2)). The injury did not have to be physical in nature to be considered non taxable. Congress stepped in to revise the tax law to restrict the tax exclusion. Several court decisions later, in 1996, the code changed to state that gross income generally does not include the amount of any damages because of personal physical injuries or physical sickness. It also provides that emotional distress is not treated as a physical injury or physical sickness except to the extent of damages paid for medical care as described in Section 213(d)(1)(A) or (B). All of that aside, the 1996 statutes offer guidance on the standards of allocating the settlement awards for taxpayers.

For tax purposes, several of the requirements for excluding the damage awards under the statutory and common law are:

• The damages must be for physical injuries.
• There must be a reasonable allocation.
• The agreed-to allocation must be specified in the settlement agreement.

Remember, the settlement stage of the negotiations is probably the most important part of your tax planning. Be sure you have a thorough understanding of your settlement agreement and the tax consequences. For more information contact Henssler Financial at 770-429-9166 or experts@henssler.com.

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