Did you get money in 2018 for your workers compensation case or your personal injury case? You’ve probably never really worried about it because your employer withholds either just enough or more than enough from you paycheck to cover your taxes and you expect a refund. This year, however, you settled that personal injury or workers comp case for five, six, or seven figures! Congratulations you successfully litigated and resolved your claim!
But tax day is coming. And fear sets in because you start thinking, “how much will I have to pay to Uncle Sam?” The question “what do I do with that income?” swirls about your mind. Surely it is an “accession to wealth” which is taxable income under our current tax code. But it shouldn’t be taxable because I only got it for getting hurt.
Have I got good news for you!
Section 104(a)(2) of the Tax Code excludes from gross income “the amount of any damages (other than punitive damages) received . . . on account of personal physical injuries or physical sickness.”
Seem clear? Perhaps clear as mud. What about lost wages? What about pain and suffering? What about reimbursement for medical expenses?
The U.S. Supreme Court touched on these things once a long time ago. Here is what the Court said:
Consideration of a typical recovery in a personal injury case illustrates the usual meaning of “on account of personal injuries.” Assume that a taxpayer is in an automobile accident, is injured, and as a result of that injury suffers (a) medical expenses, (b) lost wages, and (c) pain, suffering, and emotional distress that cannot be measured with precision. If the taxpayer settles a resulting lawsuit for $30,000 (and if the taxpayer has not previously deducted her medical expenses, see § 104(a)), the entire $30,000 would be excludable under § 104(a)(2). The medical expenses for injuries arising out of the accident clearly constitute damages received “on account of personal injuries.” Similarly, the portion of the settlement intended to compensate for pain and suffering constitutes damages “on account of personal injury.” Finally, the recovery for lost wages is also excludable as being “on account of personal injuries,” as long as the lost wages resulted from time in which the taxpayer was out of work as a result of her injuries. See, e.g., Threlkeld v. Commissioner, 87 T.C. 1294, 1300 (1986) (hypothetical surgeon who loses finger through tortious conduct may exclude any recovery for lost wages because “[t]his injury . . . will also undoubtedly cause special damages including loss of future income”), aff’d, 848 F.2d 81 (6th Cir. 1988). The critical point this hypothetical illustrates is that each element of the settlement is recoverable not simply because the taxpayer received a tort settlement, but rather because each element of the settlement satisfies the requirement set forth in § 104(a)(2) (and in all of the other subsections of § 104(a)) that the damages were received “on account of personal injuries or sickness.”
Commissioner v. Schleier, 515 U.S. 323, 329-330 (1995). Congress modified the statutory language to limit the exclusion to personal physical injuries as opposed to personal injuries. The Treasury regs state that the action must be a tort or a tort-type right.
With respect to a wrongful death beneficiary, the House Committee Report on Small Business Job Protection Act of 1996 (H.R. 3448) says that if the claim has its origin in a physical injury, it is not necessary that the recipient of the damages is the individual who suffered the physical injury. The report stated that “. . . damages (other than punitive damages) received by an individual on account of a claim for loss of consortium due to the physical injury or sickness of such individuals spouse are excludable from gross income. In addition, damages (other than punitive damages) received on account of a claim of wrongful death continue to be excludable from taxable income as under present law.” p. 301. Thus, the legislative history interprets the statutory language to exclude wrongful death settlements/verdicts too.
Rest easy friends. If you resolved a personal injury or workers comp case last year, you do not have to include it in you taxable income unless it is for punitive damages. If you have specific questions, you should consult a tax lawyer or a CPA for advice related to you particular circumstances.