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Irs Audit Guide for Lawsuit Settlement Awards 2001

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IRS Releases MSSP Audit Guide for Lawsuit Awards
The Service has released a Market Segment Specialization Program audit guide that
contains examination techniques for lawsuit awards and settlements.
Document Type: IRS MSSP Audit Technique Guides
Tax Analysts Document Number: Doc 2001-2574 (72 original pages)
Tax Analysts Electronic Citation: 2001 TNT 18-6
Citations: MSSP Audit Guide for Lawsuit Awards and Settlements (January 1,2001)

SUMMARY ===========
The Service has released a Market Segment Specialization Program audit guide that
contains examination techniques for lawsuit awards and settlements. The guide explains
how to identify tax retums with lawsuit payment issues. It also contains suggestions for
conducting examinations, explanations of applicable terminology, synopses of related
court cases, and samples of pertinent fonlls.


= = = = = = = = = FULL

TEXT ==========
The taxpayer names and addresses shown in this publication are
hypothetical. They were chosen at random fi'om a list of names of
American colleges and universities as shown in Webster's
Dictionmy or from a list of names of counties in the United
States Government Printing Office Style Manual.
This material was designed specifically for training purposes
only. Under no circumstances should the contents be used or
cited as authority for setting or sustaining a technical
Training 3123-009 (11-00)
TPDS No. 86391G
Chapter 1, ISSUES
Issues for Lawsuit Proceeds Received Prior to August 21, 1996
Issues for Lawsuit Proceeds ReceivedAfter August 20, 1996.

Types of Claims
Types of Damages/Awards
Types of Settlements
Tax Treatment of Awards and Settlements
Payroll and Self-Employment Tax Considerations
Amount to be Included in Income
Deduction for Attorneys' Fees
Legal Fees Relating to Non-Taxable Awards or Settlements
Accrued Interest on Court Judgments
Newspaper Articles
Courthouse Research
Computerized Data
Settlement Payors
State Department of Insurance
State Supreme Court Librmy
Third Party Letter
Issuance of Summons
"John Doe" Summons
Third Party Summonses
Other Considerations
Attorney-Client Privilege
Identifying the Taxpayer
InfOlmation Necessary for the Examination Case File
Scope of Examination
Examination Action Plan
Chapter 8, PENALTIES
Reporting of Damage Awards on Forms 1099-MISC
Reporting Payments to Attorneys on Form 1099-MISC

Wrongful Death
Age Discrimination
Sex Discrimination
Discrimination Cases Prior to Burke and Schleier
Employment Related
Legal Fees
Insurance Company Cases
Appendix A, Sample Lawsuit Information Data Sheet
Appendix B, Sample Attachment to Letter
Appendix C, Information Document Request
Appendix D, Excerpts from Legislative History of 1996 Amendment
NOTE: Because a business entity cannot suffer a personal injury
within the meaning ofIRC section 104(a)(2), P & X Markets, Inc.
v. Commissioner, 106 T.C. 441 (1996), aff'd in unpublished
order, (9th Cir., Feb. 13, 1988), this guide applies to
recoveries by individuals only.

[1] The infOlmation and techniques presented in this guide for lawsuit settlement
examinations were developed during a project in Alabama, which began with media
coverage of relevant tax issues. Analyses of newspaper articles revealed that numerous
lawsuits were being resolved in the state either by verdict or settlement for substantial
amounts. As a result, a separate proj ect relating only to lawsuit verdicts and settlements
was initiated and approved.
[2] Early results of the project revealed that the vast majority of these lawsuit verdicts
and settlements were escaping taxation. Virtually none of the payments were reported on
Forms 1099. For this reason, it has been easy for these payments to fall through the gap
of unreported income.
[3] In the examination of 1994 and 1995 returns, it was often found that the taxpayer hlld
classified all or most of the settlement as "compensatory," usually for "personal injuries,"
and therefore arrived at the determination that the proceeds were nontaxable. This pattern
was fonnd to be repeated in vhtually all of the lawsuit cases, regardless of whether the
claims were for fraudulent actions, defamation of character, employment related disputes,
product liability, negligence, wrongful death, etc., and also regardless ofwhether or not
claims for punitive damages were involved in the cases.
[4] On the surface, the issue seems quite simple: Internal Revenue Code (IRC) section 61
states that all income from whatever source derived is taxable, unless specifically
excluded by another Code section. In certain situations an amount of a lawsuit settlement
might be paid to reimburse a taxpayer for losses, and no gain would have to be
recognized under IRC section 1001 because the amount paid did not exceed the

taxpayer's basis (retum of capital). However, the only provision which specifically
addresses income exclusions for any type of lawsuit proceeds is IRC section 104(a)(2).
Prior to its amendment in 1996, this section excluded from income amounts paid by suit
or agreement for personal injuries or sickness. This is the section which taxpayers have
most often relied upon for authority to exclude from income lawsuit proceeds of all
kinds, including punitive damages. This is where the appearance of a simple issue
[5] IRC section 104(a)(2) has been extensively litigated. The questions have centered on
determining "what are personal injuries" for purposes ofIRC section 104(a)(2). The
issues have encompassed PHYSICAL versusNON-PHYSICAL (mental anguish) injuries
and sickness, and whether punitive damages are received on account of personal injuries.
'Iii 1989, Congress amendedIRC section 104(a)(2) referencing punitive damages and
non-physical injuries. However, due to the manner in which the statement was worded,
the 1989 amendment only created more controversy. The Service's CUlTent position is that
punitive damages are not received on account of personal injuries under IRC section
104(a)(2), and therefore are not excludable from gross income. In 1996, on the heels of
several court decisions that had upheld the Service's position, Congress resolved the
controversy and amended IRC section 104(a)(2). The 1996 changes clearly provide that
punitive damages are not excludable under IRC section 104(a)(2), regardless of whether
received in connection with a physical or non- physical injury or sickness. However, the
1996 amendment to IRC section 104(a)(2) has raised the issue whether punitive damages
received in connection with a wrongful death are excludable from gross income. This
question is discussed in detail in a subsequent section.
[6] The 1996 changes fu11her provide that amounts excludable for emotional distress are
limited to actual "out of pocket" medical costs in cases of non-physical injuries, such as
discrimination, fraud, etc. However, all amounts received on account of a physical injury,
with the exception of punitive damages, are excludable under IRC section 104(a)(2),
including amounts for emotional distress. These clarifying and limiting changes to the
statute are effective for amounts received after August 20, 1996, unless received under a
binding written agreement, court decree, or mediation award in effect on (or issued on or
before) September 13, 1995.
[7] Although lawsuit settlements of clearly designated punitive damages received after
August 20, 1996, should be easily identified by the taxpayers and the preparers as taxable
proceeds, there are still issues for examination. This guide will provide infOlmation on
how to identify tax retums with lawsuit payment issues, suggestions on conducting the
examination; detail of issues, explanations of applicable terminology, synopses of several
related court cases, and exhibits of pertinent forms.
[8] The following brief synopsis reflects the similatities and differences between the
potential issues which may arise in lawsuit verdicts and settlements received prior to
August 21, 1996, and those received on or subsequent to that date.
1. Settlement proceeds are unrep0l1ed.
2. All punitive damages are taxable whether received in relation

to a physical or non-physical injmy (caution: Alabama
wrongful death cases).
3. Determine if any ofthe settlement proceeds are designated as
interest, and if so, whether such interest is repOited as
4. For out of court settlements, determine if the taxpayer
reported correct allocations between taxable type awards,
such as punitive, back wages, etc., and non-taxable amounts,
such as emotional distress damages (caution: back pay may be
excludable if received under circumstances described in Rev.
Rul. 93-88, 1993-2 C.B. 61, obsoleted by Rev. Rul. 96-65,
1996-2 C.B. 6)
5. VerifY that the taxpayer reported taxable amounts at gross
rather than reporting them net oflegal fees.
6. Allowable legal fees should be deducted on Schedule A as
miscellaneous itemized deductions, unless the origin of the
claim litigated is related to a Schedule C (independent
contractor), or a capital transaction. TillS GUIDE DOES NOT
7. The legal fees deducted on Schedule A are a tax preference
item for purposes of Altemative Minimum Tax (AMT).
8. For purposes of the AMT Credit, the legal fees which created
AMT, are not allowed to generate the credit. They are
"exclusion" items.
I. Lawsuit proceeds are unrepolted.
2. All punitive damages are taxable whether received in relation
to a physical or non-physical injmy (caution: Alabama
wrongful death cases).
3. Detennine if any of the settlement proceeds are designated as
interest, and if so, such interest is reported as income.
4. VerifY that amounts excluded from income were received in a
case ofphysical injmy. If it was not a physical injury, the
only amounts excludable under IRC section 104(a)(2) are out
of pocket costs for medical expenses incurred to treat

emotional distress.
5. For out of court settlements for physical injury cases,
determine if proper amounts were allocated between
compensatory and punitive damages.
6. Verify the amount of out of pocket expense excluded for
emotional distress in a non-physical injury case (that is,
discrimination, fraud, etc.).
7. Verify that the taxpayer reported taxable amounts at gross
rather than reporting them net of legal fees paid.
8. Allowable legal fees should be deducted on Schedule A as
miscellaneous itemized deductions, unless the origin of the
claim litigated is related to a Schedule C (independent
contractor), or a capital transaction. TillS GUIDE DOES NOT
9. The legal fees deducted on Schedule A are a tax preference
item for purposes of AMT.
10. For purposes of the AMT Credit, the legal fees which created
AMT, are not allowed to generate the credit. They are
"exclusion" items.
[9] This comparison of issues before and after the 1996 law changes clearly reflects the
fact that there is still much potential for adjustments in the area oflawsuit payments. By
the time this guide is available service wide, a large portion of the examinations will
probably be relating to post-August 20, 1996, payments. However, there may still be
some pre-August 21, 1996, cases as well. For this reason, this guide provides assistance
in examining the taxability of settlement payments received both on or prior and
subsequent to, the amendment to IRC section 104 on August 20, i996. (NOTE THE
[10] For taxable years beginning after August 20, 1996, there will still be issues relating
to allocations in out-of-court settlements. The allocation issues :will be particularly
important in out-of-court settlements for physical injury cases. Because many cases are
settled to avoid the imposition of punitive damages, it is anticipated that the som~
taxpayers may erroneously allocate amounts between excludable and punitive damages in
these cases. The allocation issue will not be as important in the non-physical cases
because only out-of-pocket expenses for emotional distress are excludable under IRC
section 104(a)(2) after August 20,1996.
[11] General rule relative to taxability of amounts received from lawsuit settlements:

IRC section 61 states that all income is taxable from whatever
source derived, unless exempted by another section of the Code.
Types of Claims
o May cause or constitute, but is not necessarily, a personal
o Any wrongful act, not involving breach of contract, for which a
civil suit can be brought;
o A wrongful act committed by one person against another person or
his/her property;
o The breach of a legal duty imposed by law, other than by
Example 1
X punches Y, thus committing the tOlt of battery.
Example 2
X sets foot on Y's property, thus committing the tort of
trespass, but causing no personal injmy.
o Claims based on rights given by contract.
Example 3
X forces Y to leave his employment before the time specified in
an employment contract, thereby breaching the contractual
Example 4
X refuses to pay Y the amount specified in a homebuilding
contract, thereby breaching the contractual agreement.
The tort offense was committed:

o Knowingly
o Willingly
o Deliberately
o Negligently
o Fraudulently.
[12] Generally, punitive damages are not awarded for simple breach of contract, although
lawsuits often combine claims for breach of contract and related tort claims in the same
Types of Damages/Awards
o May be received from litigation or settlement of a claim for
physical injury or illness; mental pain and suffering;
interference with economic relations and/or property damage.
o Usually non-taxable if received in connection with a physical

illiury or sickness. Property damages are not excludable under
IRC section 104(a)(2). Damages received for invasions of
economic interests are generally taxable. See Gregg v.
Commissioner, T.C. Memo. 1999-10.
1. Tax Benefit Rule -- If prior deductions under IRC
section 213 were taken (that is, medical deductions;
interest expense, etc.) then amounts received for
reimbursement of these expenses would be taxable to the
extent includable under IRC section 111.
2. CompensatOly awards from tort claims which represent
lost business receipts, or other categories of taxable
income may be includable in income.
o A remedy provided specifically by the contractual agreement or
as interpreted by a court.
o Often paid for lost wages and benefits, profits and other forms
of business receipts.

o Usually taxable.
o However, some 'amounts may be non-taxable, for example, X
receives an insurance policy to replace one previously purchased
that had lapsed due to an insurance agent's misappropriation of
premiums paid.
[13] Generally speaking, most people view the term "compensatory" to mean
"nontaxable." However, as the above examples reflect, determinations of the taxability of
lawsuit awards cannot always be made simply by referring to the tenninology used, that
is, compensat01Y or contractual.
[14] The term "compensatory" merely means that the payment compensated the taxpayer
for a loss. This loss may be purely economic, for example, arising out of a contract, or
personal, for example, sustained by virtue of a physical injury. Furthermore, not all torts
constitute personal injuries. Some t01is may involve invasion of propeliy rights, for
example, conversion, or interference with economic interests, for example, tortious
interference with contractual relations, or purely personal interests, for example,
defamation. Further, even in tort cases, where the damages compensate for the
aggravated manner in which the defendant committed the tortious act, such damages are
not received on account of any personal injury.
[15] The facts and circumstances of each lawsuit settlement must be considered to
determine the purpose for which the money was received. Then, it can be determined
whether these amounts are excludable.
o Taxable. (Caution: Alabama wrongful death proceeds)
Types of Settlements
[16] Determining the correct allocations among taxable payments and non-taxable
payments is usually the most difficult part of these examinations. There are two ways in
which settlement proceeds are originally categorized:
Jury/COUli Verdicts
[17] If damages have been clearly allocated to an identifiable claim in an adversarial
proceeding by judge or jury, the Service will usually not challenge their character
because of the impartial and objective nature of the determinations. But see Robinson v.
Commissioner, 102 T.C. 116, 122 (1994) and Kightlinger v. Commissioner, T.C. Memo.
Settlements Out of Court
[18] Many lawsuits are settled prior to a jury verdict. These settlements should be closely
reviewed, and facts and circumstances should be carefully determined. The allocation
among the various claims of the settlement can be challenged where the facts and
circumstances indicate that the allocation does not reflect the economic substance ofthe
settlement. See Phoenix Coal Company, Inc. v. Commissioner (CA-2) 56-1 U.S.T.C.
paragraph 9366, 231 F.2d 420 (2d Cir. 1956); Robinson v. Commissioner, 102 T.C 116,

122 (1994); Bagley v. Commissioner, 105 T.C. 396 (1995), affd, 121 F.3d 393 (8th Cir.
[19] LeFleur v. Commissioner, T.C. Memo. 1997-312 addresses the reallocation issue in
a case involving claims for breach of contract, emotional distress, and punitive damages.
In an out-of-court written settlement, the payment was allocated as $200,000 to contract,
$800,000 to emotional distress, and $0 to punitive damages. The taxpayer excluded the
$800,000 from income under IRC section 104(a)(2).
[20] The Service disregarded the terms of the written settlement agreement and
reallocated the $800,000 to contract/punitive damages. The Tax Court upheld the IRS
reallocation. Referring to the settlement, the cOUlt stated that "the allocation did not
accurately reflect the realities of the petitioner's underlying claims." In determining that
the $800,000 was not excludable under IRC section 104(a)(2), the cOUlt stated:
"In light of the facts and circumstances, we conclude that
petitioner suffered no injury to his health that could be
attributed to the actions of the defendants, and we are not
persuaded that such injury was the basis of any payment to him
by Blount."
For additional information on issues dealing with allocation or reallocation, see the
following sections on "Physical Personal InjUlY or Sickness" and "Non-Physical Personal
InjUlY or Sickness."
Tax Treatment of Awards and Settlements
[21] Awards and settlements can basically be divided into two distinct groups. One group
includes claims arising from a physical injUly and the other group includes those arising
from a non-physical injUlY. The claims from each of the two major groups will usually
fall into three categories:
I. Actual damages resulting from the physical or non-physical
2. Emotional distress damages arising from the actual physical
or non-physical injUlY; and
3. Punitive damages.
Physical Personal Injury or Sickness
IRC section 104(a)(2) provides for an exclusion from gross
income for damages received (whether by suit or agreement and
whether as lump sums or as periodic payments) on account of
J~onal injury or sICkness. .


Section 7641 of the Omnibus Budget Reconciliation Act of 1989
amended IRC section 104(a)(2) by adding flush language:
"Paragraph (2) shall not apply to any punitive damages in

connection with a case not involving physical injury or physical
sickness. " This amendment applies to punitive damages received
after July 10, 1989, in tax years ending after that date.
[22] Nevertheless, some taxpayers have erroneously failed to report as income almost all
types of awards/settlements under IRC section 104(a)(2) due to personal injury. The
Service has consistently held that compensatory damages, including lost wages, received
on account of a physical injury are excludable fi'om gross income. Rev. Rul. 85-97, 19852 C.B. 50, amplifying Rev. Rul. 61-1, 1961-1 C.B. 14. See also Commissionerv.
Schleier, 515 U.S. 323,329- 330 (1995), in which the Supreme Court, employing a
similar set of facts as the ruling, held that medical expenses not previously deducted, pain
and suffering damages, and lost wages received by accident victim are excludable from
[23] IRC section 104(a)(2) was amended in 1996. The amended section 104 a 2
of erso al h sical in'u or
exc udes from
physical sickness onlX' However, the limitation to personal physical injuries or physical
sicllliess contamed in the 1996 amendment does not apply to any amount received under
~wl'i!ten billding agreement, eOUlt decree, or mediation award in effect o~ (or issued on
~or before) September 13, 1995.
[24] The House Committee Report for the 1996 changes (excerpts attached as Appendix
, "
, , ,
D) states:
If an action ,Has its Oligin in a physical injUlY or physical
sickness, then all damages (other than punitive) that flow
therefrom 'are treat~d as payments received on account of
physical injury or physical sickness whetjler 01' not the
recipient ofthe damages is the injured party. For example,
damages (other than punitive) received by an individual on
account of a claim for loss of consortium due to the physical
injUly 01' physical sickness of such individual's spouse are
excludable from gross income.
[25] The exclusion from gross income under IRC section 104(a)(2) also applies to any
compensatory damages received based on a claim of emotional distress 01' "
mental/emotional injUly that is attribut~ble to a physical injUly or physical sickness. For
more information on damages paid for emotional injuries stemming from physical
injUly/sickness, see discussion under "Physical" above. Emotional claims pertaining to
non-physical personal injury/sickness" is covered later on in this guide.
[26] Determining the amounts allocable to mental/emotional injuries may not always be
easy. The facts and circumstances of each award/settlement must be examined, and
amounts which can be reasonably allocated to genuine mental injury should be allowed.
The allocation is necessary when economic damages, for example, back pay, or punitive
damages is requested as relief in a case involving a physical or non-physical personal
o Points to consider:

o Did payor intend to compensate the recipient for his or her
claim of mental distress? If so, how much? But see Hemelt v.
United States, 122 F.3d at 208 ("the characterization of a
settlement cannot depend entirely on the intent of the
parties") citing Dotson v. United States, 87 F.3d at 687, and
Mayberry v. United States, 151 F.3d at 859.
o What did the payor think? That is, whether he/she/it could win
or lose (elements of the claim).
o Were there medical bills for mental disturbances?
o Was there psychological treatment or counseling?
o Were there lost workdays?
o Is there documentation for medications, antidepressants, etc?
o Did this situation cause taxpayer to be absent fi'om work?
o Was there sick leave used?
o Did taxpayer continue to care for his/her family?
o Did taxpayer continue with daily affairs?
For the allocation, start with the total payment less the
actual, obvious losses, then allocate between compensatory and
Punitive Damages
o Punitive damages are not excludable from gross income under IRC
section 104(a)(2).
The position of the IRS on the taxation of punitive damages has
not been constant. In Rev. Rul. 58-418, 1958-2 C.B. 18, the
Service published its position that punitive damages do not
qualify for exclusion under IRC section 104(a)(2). See Thomson
v. Commissioner, 406 F.2d 1006, 69-1 U.S.T.C. paragraph 9199
(9th Cir. 1969). In Rev. Rul. 75-45,1975-1 C.B. 47, the
Service changed its position and concluded that punitive damages
were excludable. See Roemer v. Commissioner, 716 F.2d 693,83-2
U.S.T.C. paragraph 9600 (9th Cir. 1983), following the Service
reluctantly on this issue. Addressing the Alabama wrongful death
statute, the Service ruled that punitive damages were again

taxable. Rev. Rul. 84-108, 1984-2 C.B. 32. Accordingly, Rev.
Rul. 75-45 was revoked. See Burford v. United States, 642 F.
Supp. 635 (N.D. Ala. 1986), disagreeing with Rev. Rul. 84-108.
Prior to 1989, the courts, however, often did not agree. After
1989, some commentators believed that the courts would interpret
the additional verbiage to IRC section 104(a)(2) to exclude
punitive damages paid relative to a physical injmy or physical
However, in the Tenth Circuit's decision in O'Gilvie v. United
States, 95-2 U.S.T.C., paragraph 50,508, 66 F.3d 1550, the court
ruled that "non-compensatory punitive damages are not received
on account of personal injuries, and thus are not excludable
from gross income under IRC section 104(a)(2)."
In O'Gilvie, the Tenth Circuit applied the Supreme Court's
ruling in the case of Commissioner v. Schleier, (1995 S.Ct.), 75
AFTR 2d 95-2675; 115 S.Ct. 2159, 515 U.S. 323, involving
employment discrimination, to a case involving wrongful death.
Schleier held that there are two independent tests which must be
met for the IRC section 104(a)(2) exclusion to apply: (1) The
underlying cause of action giving rise to the recovelY must be
based on tort or tOlt-type rights; and (2) the damages must
"have been received on account of personal injuries or

Prior to this time, some of the courts had relied on only the
first requirement of a tort-type underlying claim in holding
that the damages were excludable. See, for example, Hill v.
United States, 733 F. Supp. 88, 1990-1 U.S.T.C. paragxaph 50,170
(D. Kan. 1990) (damages for tort of misrepresentation excludable
from gross income).
The Supreme Court upheld the Tenth Circuit's decision. O'Gilvie
519 U.S. 79,117 S. Ct. 452; 96-2 U.S.T.C. paragraph 50,664; 78 .
AFTR 2d 7454 (1996). With this decision, the comts finally have
clear guidance, which coincides with the Service's position on
the taxation of punitive damages prior to the 1989 amendment to
IRC section 104(a)(2).
With the enactment of Public Law 104-188, Section l605(d),
Congress made it clear in IRC section 104(a)(2) that punitive
damages are taxable, regardless of the nature of the underlying
However, the courts have not decided a case involving punitive

damages subject to the 1989 amendment to IRC section 104(a)(2).
In dictum, the Supreme Court indicated that Congress amended IRC
section 104(a)(2) in 1989 to allow the exclusion of punitive
damages only in cases involving physical injury or physical
sickness. United States v. Burke, 504 U.S. at 236, n.6. Faced
with the taxation of punitive damages prior to the 1989
amendment and the specter of addressing the 1989 amendment in a
subsequent case, the Supreme Court, retreating from the
statement in Burke, rejected the taxpayer's argument that was
based on this dictum. O'Gilvie, 519 U.S. at 89-90. The Court
indicated that Congress' focus in 1989 was on what to do about
non-physical personal injuries rather than on punitive damages
under prior law. The Court's statement lays to rest the negative
inference and provides support for the conclusion that, in
enacting the 1989 amendment, Congress did not intend to create
an exclusion for punitive damages received in connection with a
physical injmy or physical sickness. See, also, Miller v.
Conunissioner, 914 F.2d 586,588, n. 4 (4th Cir. 1990)
(Congress has amended IRC section 104(a)(2) so that it now
explicitly does not exclude from gross income "punitive damages
received in connection with a case not involving physical injury
or physical sickness.")
Wrongful Death
[27] Claims for wrongful death usually encompass compensatory damages for physical
and mental injury, as well as punitive damages for reckless, malicious, or reprehensible
conduct. As a result, both claims may generate settlement amounts. Any amounts
determined to be compensatOlY for the personal injuries are excludable from gross
income under IRC section 104(a)(2). The amounts determined to be non- compensatOly,
that is, punitive payments, are not excludable under IRC section 104(a)(2). This is true
regardless of whether the punitive amounts are received prior or subsequent to the August
20, 1996, amendment. (See O'Gilvie, 519 U.S. 79, 117 S. Ct. 452; 96-2 U.S.T.C.
paragraph 50,664; 78 AFTR 2d 7454.)
[28] The exclusion available for personal injuries under IRC section 104(a)(2), as of
August 20, 1996, reads as follows:
,,* * * the amount of any damages (other than punitive
damages) received (whether by suit or agreement and whether as
lump sums or as periodic payments) on account ofpersonal
physical injuries or physical sickness."
[29] As mentioned previously, caution should be used in applying this general rule that
punitive damages received in wrongful death cases are taxable. The courts have generally
looked to the state statute under which the wrongful death claim was litigated to
determine whether there could be compensatOlY and/or punitive damages awarded. This
search, at times, has revealed a state statute, which provides only for punitive damages in
wrongful death claims. One court has ruled, that such damages received in wrongful

death cases in that state are excludable from income. Burford v. United States, 642 F.
Supp. 635 (N.D. Ala. 1986). The court's reasoning was that because the taxpayer is
precluded from receiving any compensatory amounts, it is unfair to tax the amounts
although they were classified as punitive.
[30] Questions have arisen as to whether the 1996 amendment codified this judicial
treatment of punitive damages in Burford. A new provision, IRC section 104(c), provides
as follows:
(c) Application of prior law in certain cases.
The phrase "other than punitive damages" shall not apply to
punitive damages awarded in a civil action --

(1) which is a wrongful death action, and
(2) with respect to which applicable State law (as in effect on
September 13, 1995, and without regard to any modification after
such date) provides, or has been construed to provide by a cOUlt
of competent jurisdiction pursuant to a decision issued on or
before September 13, 1995, that only punitive damages may be
awarded in such an action.
[31] Due to the inference raised by this language in the wrongful death claims area, it
may become necessary to determine if your state is one having a statute precluding the
awarding of compensatory damages in wrongful death cases. If that is the case, then
contact the Office of Chief Counsel for guidance on Service position.
Product Liability
[32] Product liability cases often include claims for personal physical and mental injUly.
For example, X brings a claim for personal injury against an auto manufacturer claiming
a wreck was caused by a faulty steering column on his car, or Y brings suit against the
manufacturer of a contaminated pesticide claiming damage to ornamental plants and the
nursery, and injury to business reputation.
[33] These type cases will usually involve the various elements discussed above, relative
to compensatory damages for physical and mental injury, as well as punitive damages.
Proper allocations among the taxable and nontaxable pOltions received must be
Non-Physical Personal InjUlY or Sickness
[34] Prior to the amendment of August 20, 1996, the Service and the courts consistently
intetpreted IRC section 104(a)(2) as providing an exclusion for damages received in
connection with claims of mental and emotional distress which arose from non-physical
injuries. Examples of these type cases are employment wrongful discharge;
discrimination; libel; etc. Exclusions from gross income have been widely debated in
prior years. Generally, the Service has challenged taxpayers' allocation of settlement
proceeds to compensatory damages for mental/emotional distress when those allocations
do not reasonably reflect the economics of the underlying claim. Thus, whether the
Service must respect the specific allocations contained in a settlement agreement has
arisen in several cases. The same considerations to proper allocations for emotional

claims that were discussed earlier under "physical injuries" are applicable to the nonphysical cases as well. (Refer to connnents under "Emotional".)
[35] The August 20, 1996, amendment has plainly resolved this issue on the side of the
Government. With the exception of amounts paid to treat emotional distress, damages
received after August 20, 1996, are excludable under IRC section 104(a)(2) only if
received on account ofphysical injury or physical sickness.
[36] The 1996 amendment changed the last sentence in paragraph (a) ofIRC section 104
to include the following:
For purposes of paragraph (2), emotional distress shall not be
treated as a physical injury or physical sickness. The preceding
sentence shall not apply to an amount of damages not in excess
ofthe amount paid for medical care (described in subparagraph
(A) or (B) of section 213(d)(l)) attributable to emotional
[37] The House Committee Report on the 1996 amendment to IRC section 104(a)(2)
* * * the exclusion from gross income does not apply to any
damages received (other than for medical expenses as discussed
below) based on a claim of employment discrimination or injury
to reputation accompanied by a claim of emotional distress
* * * In addition, the exclusion from gross income specifically
applies to the amount of damages received that is not in excess
of the amount paid for medical care attributable to emotional
[38] As a result of the above 1996 changes to IRC section 104(a)(2), a taxpayer receiving
lawsuit proceeds from a non-physical injury claim cannot exclude any amount for
payment to compensate for an intangible emotional distress value The taxpayer can only
exclude an amount for actual out of pocket medical costs. This exclusion would further
depend upon whether the taxpayer had previously deducted those medical expenses on
his or her tax return. See IRC sections 111 and 213.
Employment-related lawsuits may arise from wrongful discharge or
failure to honor contract obligations. Whether a wrongful
termination constitutes a tort under applicable state law is not
controlling for IRC section 104(a)(2) purposes. As indicated
earlier, the victim of a tOlt may suffer both personal injury
and economic loss. Damages received to compensate for economic
loss, for example, lost wages, business income, benefits, are
not excludable from gross income unless a personal injury caused
such loss.
[39] If the payments in question are received prior to the 1996 amendment, there may be
issues concerning the proper allocation between taxable and nontaxable proceeds. The

taxpayer may be seeking to exclude substantial amounts for emotional/mental distress.
After the 1996 changes, the taxpayer can exclude under IRC' section 104(a)(2) only an
amount of damages received not exceeding medical costs paid to treat any emotional
Discrimination Suits (Employment-Related)
[40] Discrimination suits usually are brought alleging infringements in the areas of age,
race, gender, religion or disability. These types of cases can generate compensatory,
contractual and punitive awards. Historically, the courts have usually looked to the
underlying-cause-of-action statute to determine the nature of remedies allowed for the
various types of discrimination.
[41] Some comis, and, for a short time, the Service, pennitted taxpayers to exclude
amounts awarded which actually represented back pay. Rev. Rul. 93-88 was based on the
interpretation of the Supreme Court's ruling in Burke, 504 U. S. 229 (69 AFTR 2d 921293). Rev. Rul. 93-88 held that amounts received under the following provisions,
including, not only amounts for non-pecuniary losses, but back pay as well, were
excludable under IRC section 104(a)(2):
1. Gender discrimination claims under the disparate treatment
provisions of Title VII of the Civil Rights Act of 1964, 42
U.S.C. section 2000e et seq., as amended by the Civil Rights
Act of 1991,42 U.S.C. section 1981a;
2. Racial discrimination claims under, 42 U.S.C., section 1981,
and Title VII of the Civil Rights Act of 1964; and
3. Discrimination claims under the Americans with Disabilities
Act, 42 U.S.C. sections 12101-12213.
[42] The decision of the Supreme Court in the Schleier case, (1995, S. Ct.) 515 U.S. 323,
115 S. Ct. 2159, caused the Service to suspend Rev. Rul. 93-88 with the issuance of
Notice 95-45, 1995-2 C.B. 330, on August 3, 1995. Notice 95-45 stated the following:
In Schleier, the Supreme Court held that back pay and liquidated
damages received in settlement of a claim under the Age
Discrimination in Employment Act of 1967,29 U.S.C sections 621634 (ADEA), are not excludable from gross income under section
104(a)(2). The Court concluded that section 104(a)(2) and its
regulations set forth two requirements for a recovery to be
excludable from income: (1) it must be based on tort or torttype rights, and (2) it must be received "on account of personal
injuries or sickness." The Court held that back pay and
liquidated damages received under the ADEA meet neither
requirement because (l) the ADEA provides no compensation for
any of the other traditional harms associated with personal
injury, (2) the back pay is completely independent of the
existence or extent of any personal injury, and (3) the ADEA
liquidated damages are punitive in nature.

[43] In Notice 95-45, the Service requested public comments concerning the impact of
Schleier on the above listed statutes; allocation ofthe excludable and nonexcludable
portions of lump-sum awards and settlements; and the extent to which IRC section
7805(b) relief should be granted in the event that guidance previously issued by the
Service is modified. Notice 95-45 was superseded when the Service published Rev. Rul.
96-65, 1996-2 C.B. 6, in December of 1996.
[44] After providing a brief history of the law and rulings relating to the discrimination
cases, Rev. Rul. 96-65 holds:
1) Current section 104(a)(2) -- (after August 20,1996) Back pay
received in satisfaction of a claim for denial of a promotion
due to disparate treatment employment discrimination under Title
VII is not excludable from gross income under section 104(a)(2)
because it is completely independent of, and thus is not damages
received on account of, personal physical injuries or physical
sickness under that section. Similarly, amounts received for
emotional distress in satisfaction of such a claim are not
excludable from gross income under section 104(a)(2), except to
the extent they are damages paid for medical care (as described
in section 213(d)(l )(A) or (B» attributable to emotional
2) Former section 104(a)(2). Back pay received in satisfaction
of a claim for denial of a promotion due to disparate treatment
employment discrimination under Title VII is not excludable from
gross income under former section 104(a)(2) because it is
completely independent of, and thus is not damages received on
account of, personal injuries or sickness under that section.
However, damages received for emotional distress in satisfaction
of such a claim are excludable from gross income under former
section 104(a)(2) because they are received "on account of
personal injuries of sickness."
[45] Pursuant to the authority contained in IRC section 7805(b), Rev. Rul. 96-65 will not
apply adversely to damages received under any provision of law providing tort or torttype remedies for employment discrimination for race, color, religion, gender, national
origin, or other similar classifications, if the damages are received (1) on or before June
14, 1995, the date that Schleier was decided by the Supreme Court, or (2) pursuant to a
written binding agreement, court decree, or mediation award in effect on (or issued on or
before) June 14, 1995.
[46] Rev. Rul. 96-65 also contains information conceming its effect on other IUlings and
references to treatment of amounts as wages and compensation. Rev. Ru1. 96-65 should
be consulted for guidance in certain employment discrimination cases. The provisions of
Rev. Rul. 96-65 apply to proceeds received for employment discrimination that is also
prohibited by certain state and local laws. Rev. Rul. 93-88, although made obsolete by
Rev. Rul. 96-65, contains a good explanation of various discrimination statutes.
Libel (Defamation of Character)

[47] Prior to the 1996 amendment to IRC section 104, the government and the courts
were at odds on the proper tax treatment of awards due to damage of business reputation.
The government took the position that these damages could not be excluded from
income. See Rev. Rul. 58-418, 1958-2 C.B. 18.
[48] Although the Tax Court initially agreed with the government, Roemer v.
Commissioner, 79 T.C. 398 (1982), rev'd, 716 F.2d 693 (9th Cir. 1983), it adopted the
circuit court's rationale in Threlkeld v. Commissioner, 87 T.C. 1294 (1986), aff'd, 848
F.2d 81 (6th Cir. 1988). As a result, the cOUlis allowed taxpayers to exclude from gross
income compensatory amounts received for injUly to business reputation and malicious
prosecution. See also Srivastava v. Commissioner, T.C. Memo. 1998-362 (defamation of
a person is a personal injury under state law).
[49] Recently, however, the Tax COUli revisited this issue and concluded that damages
received for injury to the taxpayer's business or professional reputation failed to qualifY
for the IRC section 104(a)(2) exclusion. Fabry v. Commissioner, 111 T.C. 305 (1998).
The court held that whether damage to an individual's business or professional reputation
constitutes a personal injury for IRC section 104(a)(2) purposes is an issue offact, rather
than a question of law. Because the taxpayer failed to allege any personal injUly in the
underlying product liability action, the court concluded that the portion ofthe proceeds
allocable to injUly to taxpayer's business reputation was not excludable under IRC section
104(a)(2). FablY was decided under IRC section 104(a)(2) as it existed prior to the 1996
[50] However, the 1996 changes to IRC section 104(a)(2) should resolve this issue on the
side of the government as well. Because damage to reputation, be it personal or business,
is a non-physical injury, only out of pocket costs to treat emotional distress can be
excluded. Any other compensatory and punitive damages arising from these cases are
Other Non-Physical Personal Injury
[51] Lawsuits against insurance companies, fmance companies, etc., for negligence,
fraud, breach of contract, etc., can include a variety of claims, and therefore can produce
a variety oftypes of awards/settlements.
[52] For amounts received prior to August 21, 1996, the facts and circumstances of each
case must be analyzed to determine the reasonable allocations between taxable and
nontaxable amounts. Some taxpayers may en'oneously categorize punitive damages and
other non- compensatory amounts received in these cases as amounts received for
personal injuries related to emotional distress.
[53] Subsequent to August 1996, the taxable amounts in these cases are more easily
determined. Because these are nonphysical injuries, under the CUlTent version of IRC
section 104(a)(2), only out-of-pocket amounts for medical costs incurred to treat any
emotional distress claims would be excludable from income. All amounts detennined to
represent punitive damages are taxable.
[54] Questions may arise concerning pursuit of employment taxes on cases involving
employment-related issues, and self-employment taxes on cases involving payments to
self-employed persons related to their trade or business.

[55] The employment taxes that may apply include the taxes imposed under the Federal
Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA), and
the Collection ofIncome Tax at Source on Wages (income tax withholding). If the
taxpayer is a railroad employer, the Railroad Retirement Tax Act (RRTA) may apply.
FICA taxes, FUTA taxes, and income tax withholding are imposed on "wages" as defined
in the Internal Revenue Code. "Wages" is broadly defined as "all remuneration for
employment," with certain specific exceptions, for FICA and FUTA purposes (IRC
sections 3l2l(a) and 3306(b), respectively) and "all remuneration for services perfOlmed
by an employee for his employer," again with specific exceptions, for income tax
withholding purposes (IRC section 340l(a».
[56] In determining the status of settlement payments, keep in mind the broad defmitions
of "wages." See Social Security Board v. Nierotko, 327 U.S. 358 (1946), and Remelt v.
United States, 122 F.3d 204,209-211 (4th Cir. 1997).
[57] Be aware that the label placed on settlement payments by the plaintiff and the
defendant does not necessarily control the employment tax treatment of such payments.
Because both parties generally benefit by classiJYing payments as non-wage payments,
the specific portion of a settlement agreement allocating payments to non-wage payments
is generally not based on an arm's length negotiation between adverse parties.
[58] An allocation of the settlement that is reasonable and based on the facts and
circumstances ofthe case should generally be accepted by the Service. A statement by
the employer that the settlement payment was made merely to settle the case is of little
value in determining whether the payment is wages for employment tax purposes.
Generally, if no specific allocation of the settlement is made, the status of the payments
would be determined by looking at the claims asserted by the plaintiff and the
surrounding facts and circumstances, including the basis upon which the settlement
proceeds were distributed. There has been a considerable amount of litigation in
counection with the employment taxation of settlement payments, therefore, before
relying on any particular case, care should be taken to veriJY that the case accurately
reflects Service position.
[59] There is general agreement that to the extent damages are excludable from gross
income, they are not subject to employment taxes. Also, there is general agreement
among courts that to the extent a settlement payment made by an employer or former
employer represents back pay for services by an employee for the employer, such
payments are wages for employment tax purposes. Rev. Rul. 96-65, 1996-2 C.B. 6.
[60] Back pay paid to an employee or former employee by an employer in a settlement
related to a claim under a workers' right statute or civil rights statute for a period during
which no services were performed by the employee is also wages for federal employment
tax purposes. Typically, back pay is awarded if an employee is illegally telminated by an
employer, and, under those circumstances, the back pay relates to a period when no
services for the employer were pelfOlmed by the employee because ofthe illegal
termination. The position that back pay is wages even though it is attributable to a period
during which actual services were not performed is based on the Supreme Comt's holding
in Social Security Board v. Nierotko, 327 U.S. 358 (1946), in which back pay awarded to
an illegally telmrnated employee under the Fair Labor Standards Act (FLSA) was held to
be wages for social security benefit purposes.
[61] Nierotko has been applied in determining that wages for federal employment tax

purposes includes back pay paid under a number of different workers' rights and civil
rights statutes (for example, the Back Pay Act, the Age Discrimination in Employment
Act (ADEA), and Title VII of the Civil Rights Act of 1964, and state and local
discrimination statutes). See Tanaka v. Department ofNavy, 788 F.2d 1552, 1553 (Fed.
Cir. 1986), andBlim v. Western Electric Co., 731 F.2d 1473,1480 n.2 (10th Cir. 1980).
But see Churchill v. Star Enterprises, 3 F. Supp. 2d 622, 624-25 (E.D. Pa. 1998) holding
that an employer could not withhold FICA or income taxes from damages awarded for a
violation of the Family and Medical Leave Act, 29 U.S.C. section 2601 et seq, because
the employee was not perfonning services for the employer during the period for which
the damages were awarded.
[62] Service position is that "front pay", which is pay awarded to the employee for future
services (that is, generally service fi'om the date of the settlement going forward) the
employee would have performed but for the illegal actions of the employer, is also wages
for federal employment tax purposes. Some courts have disagreed with this position. See
Dotson v. United States, 87 F.3d 682, 690 (5th Cir. 1996), holding that payments are not
wages if not for services already perfonned. However, Nierotko SUppOltS the Service
position. In addition, Service position is that settlements including cash payments made
to employees by employers in lieu of providing benefits under employer plans (for
example, paid in lieu of health insurance or qualified pension plan benefits) are also
wages for federal employment tax purposes, because no exception from wages applies.
[63] Back pay and front pay are wages subject to employment taxes in the year paid, and
are subject to the tax rates and FICA and FUTA wage bases in effect in the year paid. See
Rev. Rul. 89-35, 1989-1 C.B. 280; Hemelt v. United States, 122 F.3d 204, 210 (4th Cir.
1997); and Mazur v. Commissioner, 386 F. Supp. 752 (W.D. N.Y. 1997). The Service
does not follow Bowman v. United States, 824 F.2d 528 (6th Cir. 1987), on the timing of
FICA taxation of back pay issue.
[64] There has been much litigation in the area ofthe employment tax status of settlement
agreements, and the Service position has not been followed in many cases. For example,
the issue of whether celtain payments in settlement ofa suit for violation of Employee
Retirement Income Security Act (ERISA) are subject to income and FlCA taxes has been
litigated in four circuits. These cases related to a class action brought by former
employees of an employer who engaged in a scheme ofterminating employees before
they qualified for celtain pension benefits. Two circuits agreed with the Government's
position that the full amount ofthe settlements were includable in income and subject to
FICA taxes. See Hemelt v. United States, 122 F.3d 204 (4th Cir. 1997), and Mayberry v.
United States, 151 F.3d 855 (8th Cir. 1998). However, in Dotson v. United States, 87
F.3d 682 (5th Cir. 1996), the Fifth Circuit Coult of Appeals held that only the back pay
poltion ofthe settlement was wages for FlCA tax purposes. In Gerbec v. United States,
164 F.3d 1015 (6th Cir. 1999), the Coult of Appeals for the Sixth Circuit held that only
the pOltions of the settlement representing back pay and the front pay not attributable to
personal injury were subject to FlCA taxes. In looking at these four cases, please be
aware that the income tax result does not reflect the recent amendment to IRC section
104(a)(2) and that the income and FICA tax results in the cases the Government lost do
not reflect Meltens v. Hewitt Associates, 508 U.S. 248 (1993), a Supreme Comt case
which provides that tort damages are not available for ERISA violations.
[65] In addition, the Service's position is that back wages and front pay paid to

individuals who are not hired as employees because of violation of workers' rights or
civil rights statutes are wages for federal employment tax purposes. See Rev. Rul. 78176, 1978-1 C.B. 303, which bases its holding on Nierotko. However, the position of this
revenue ruling was rejected in Newhouse v. McCormick & Co., 157 F.3d 582 (8th Cir.
[66] As a general rule, dismissal pay, severance pay, or other payments for involuntmy
termination of employment are wages for federal employment tax purposes. See Rev.
Rul. 90-72, 1990-2 C.B. 211, and Rev. Rul. 73-166,1973-1 C.B. 411. See also
Abrahmnsen v. United States, 44 Fed. Cl. 260 (1999), on downsizing payments. In that
consolidated case, approximately 2,600 former employees of IBM sought refunds of
income and FICA taxes on the basis that payments received under certain resource
reduction programs were excludable from gross income as personal injury damages and
consequently were not wages. Noting that none of the plaintiffs instituted a claim against
IBM before executing releases and receiving the payments, the court doubted that they
satisfied the first test for exclusion. Even if they did satisfY that test, the comi concluded
that the plaintiffs failed to satisfY the second test that the payments were received "on
account of personal injuries." On the FICA issue, the comi reasoned that because the
payments were linked to salary and length oftenure, the payments were consistent with
the notion of wages.
[67] There are a number of exceptions to wages that may apply in settlement cases. For
exmnple, legally designated interest and attomey fees may be excepted from wages. Rev.
Rul. 80-364, 1980-2 C.B. 294. Also, a limited exception exists for celiain settlement
payments made to settle claims for the cancellation of the remaining period of a contract
for a term of yem's that is terminated prior to the completion of the contract. See Rev.
Rul. 55-520, 1955-2 C.B. 393, and Rev. Rul. 58-301, 1958-1 C.B. 23. These two rulings
should be applied only when the facts of the case are identical to the rulings, and
comparison should be made with Rev. Rul. 74-252, 1974-1 C.B. 287, and Rev. Rul. 7544,1975-1 C.B.l5, before applying Rev. Rul. 55-520 or Rev. Rul. 58-301 in any
paliicular case.
[68] "Liquidated dmnages" awarded under a FLSA settlement are not wages for federal
employment tax purposes. Rev. Rul. 72-268,1972-1 C.B. 313. Under the FLSA such
liquidated damages cannot exceed the amount of back pay and must be based on a
showing of willful intent of the employer. Similar rules apply to "liquidated dmnages"
under the ADEA. Generally, bona fide damages in settlement oftort claims for personal
injury that were excludable from gross income under IRC section 104(a)(2) do not
constitute wages for federal employment tax purposes. See Hemelt, 122 F.3d at 210.
[69] In the case of a lawsuit settlement paid by an employer to an employee or former
employee, caution should be exercised in determining the existence of any employment
tax issues.
[70] In contrast to the broad definition of wages for federal employment tax purposes set
forth in Nierotko and other cases, many recent cases have adopted narrow interpretations
of what constitutes "self-employment income" for self-employment tax purposes. See
IRC section 1402(a) and (b). Under the test adopted by many courts, to be included in
self-employment income for self-employment tax purposes, "any income must arise from
some actual (whether present, past, or future) income-producing activity of the taxpayer."
See Newberryv. Commissioner, 76 T.C. 441 (1981), in which business intenuption

insurance payments paid to a self-employed individual during the period his store was
shut down because of a fire were held not to be self-employment income, and Jackson v.
Commissioner, 108 T.C. 130, in which celiain termination payments made to a retiring
insurance agent were held not to be includable in self-employment income. See, however,
Rev. Rul. 91-19,1991-1 C.B. 186, in which the Service sets forth a slightly different test
for inclusion in self-employment income.
[71] Thus, before classifying settlement payments as subj ect to self-employment tax, care
should be taken in determining that the payments can be attributed to the carrying on of a
trade or business by the self-employed person.
[72] In cases involving contingent fee anangements, the gross award/settlement, without
diminution for attomeys' fees or costs, should be included in the taxpayer's income. This
treatment is in accord with IRC section 61 and the long established principle, "the fruit of
the tree" theory, that income is taxable to the person who earns it and it cannot be
assigned to someone else.
[73] Taxing the gross amount from lawsuit proceeds has been upheld in Tax Comi, as
well as various circuit jurisdictions. See Gadlow, 50 T.C. 975, (1968)(Pennsylvania);
Baylin, 43 F.3d 1451, 94-1 U.S.T.e. paragraph 50,029 (Fed. Cir. 1993)(Maryland);
Alexander, 72 F.3d 938,96-1 U.S.T.C. paragraph 50,011 (1st Cir. 1995), afl'g T.C.
Memo. 1995-51(Massachusetts); Coady, T.C. Memo. 1998-291 aft'd, 231 F3d 1187 (9th
Cir. 2000)(Alaska); Srivastava, T.C. Memo. 1998- 362, rev'd, 86 AFTR2d paragraph
2000-5104 (Texas); Sinyard, T.C. Memo. 1998-364(Arizona); and Benci-Woodward,
T.C. Memo. 1998-395, aft'd, 86 AFTR2d paragraph 2000-5102 (9th Cir. 2000)
(Califomia); Kenseth, 114 T.C. No. 26 (May 24,2000). In Kenseth, the Tax Court held
that the anticipatory assignment principles require a taxpayer to include in gross income
the entire amount ofjudgment/settlement proceeds, undiminished by any contingent fee
and regardless of the state where a fee agreement is signed. The Tax Comi expressly
rejected the principles enunciated in cases holding to the contrary.
[74] Examiners handling cases involving payments of attorneys' fees in lawsuits in
Alabama, Michigan, and Texas, however, should be aware that there is contrary authority
based on an interpretation of applicable state law.
[75] In Cotnam v. Commissioner, 1959,263 F.2d 119, 59-1 U.S.T.C. paragraph 9200,
rev'g on this issue, 28 T.C. 947 (1957), the Fifth Circuit, one judge dissenting,
determined that attorneys' fees paid directly to the attorney from the judgment under a
contingency fee alTangement were not includable in the taxpayer's gross income. The
majority of the court reasoned that under Alabama law, attomeys had the same rights as
their clients and that Mrs. Cotnam could never have received the portion paid as
attorneys' fees. This is a case from the Fifth Circuit, prior to the time a pOliion ofthe
circuit was split offto form the Eleventh Circuit.
[76] An Action on Decision in the Cotnam case states that the Service will not follow the
court's ruling in future cases. The Government has requested the full Court of Appeals for
the Eleventh Circuit to reconsider the Cotnam decision. In Davis v. Commissioner, T.C.
Memo. 1998-248, aft'd, 210 F.3d 1346 (11th Cir. 2000), the Tax Court concluded it was
bound by Cotnam in cases arising under Alabama law, and, thus, ruled adversely to the
Commissioner. However, the Eleventh Circuit declined to reconsider Cotnam in the
Davis appeal. Similarly, the Fifth Circuit followed Cotnam in reversing the Tax Court's

decision in Srivastava. The panel agreed with the Tax Court's rationale in Kenseth but
nevertheless, the majority ofthe panel elected to follow its precedent in Cotnam. The
Service is considering whether to recommend to the Department of Justice that Supreme
Court review is appropriate and wall'anted.
[77] The Comt of Appeals for the Sixth Circuit followed Cotnam in a case arising under
the common law of Michigan. Est. of Arthur L. Clarks, 202 F.3d 854 (6th Cir. 2000).
Reversing the judgment ofthe district court, the Sixth Circuit analogized Michigan
common law of liens to the Alabama attorney lien statute. Because the Service did not
believe that the Sixth Circuit created a direct conflict with opinions arising under other
state laws, the Service did not recommend that the Government file a petition for a writ
of certiorari.
[78] Until this issue is resolved, the Action on Decision in Cotnam should be followed
and taxpayers should not be allowed to net the proceeds of the direct payment of
attorneys' fees in all cases arising under any law other than Alabama, Michigan, and
Texas. The Service erroneously excluded the attorneys' fees from the taxpayers' income
in Francisco v. United States, 85 AFTR 2d paragraph 2000-754 (E.D. Pa. 2000). Further,
in cases arising under Alabama, Michigan and Texas law, consult with the appropriate
local Office of Chief Counsel for the current status of this issue.
[79] Generally, individuals, as cash basis taxpayers, may deduct attorneys' fees in the
year they are paid, assuming the attorneys' fees otherwise qualify as deductible. In the
majority of such cases, the attorneys' fees are paid pursuant to a contingent fee
all'angement once damages have been recovered. Where the ultimate recovery is
excludable from gross income, either in whole or in part, the payment of contingent
attorneys' fees allocable to exempt income are not deductible. IRC section 265(a)(l). The
question of the timing and deductibility of attorneys' fees paid prior to resolution of the
lawsuit on a noncontingent fee basis requires additional analysis that is not practical to
provide in this guide. Examiners should consult with the appropriate Office of Chief
Counsel for guidance.
[80] Except in rare cases, such as a compensatory recovery of self-employment income,
(for example, commissions that are reported on Schedule C) or recovery of capital gain
income, legal fees will be a Schedule A miscellaneous itemized deduction, subject to the
2 percent floor and AMT. (This, of course, assumes that the lawsuit proceeds have been
taxed at gross in the taxpayer's income.) Nevertheless, the Tax Court recently held
adversely to the Commissioner that a self-employed individual could deduct legal fees
allocable to the recovery of punitive damages on Schedule C, rather than as a
miscellaneous itemized deduction on Schedule A. Guill, 112 T.C. 325 (1999).
Consequently, the court held that the punitive damages recovered by the taxpayer were
Schedule C income. The Service is considering the correctness of the court's holding and
whether an AOD will be prepared.
See: Church v. Commissioner, 80 T.C. 1104, 1110 (1983); and Alexander, 96-1 U.S.T.C.,
paragraph 50,011; and IRC section 212.
[81] No legal fee deduction will be allowed for legal fees allocable to non-taxable awards
or settlements. IRC section 265(a). Absent strong SUppOlt to the contralY, legal fees
relating to an award or settlement that is paltially taxable will be allocated based on the

ratio between the taxable award/settlement and the total award/settlement.
See Johnson-Waters, T.C. Memo. 1993-333; and Church, 80 T.C. 1104, 1110 (1983).
[82] Any interest associated with an award or settlement is always taxable. Aames, 94
T.C. 189 (1990); Kovacs, 100 T.C. 124 (l993); Brabson v. United States, 96-1 U.S.T.C.
paragraph 50,038, 74 AFTR 2d 572, 73 F.3d 1040 (lOth Cir. 1996). Some states have
enacted statutes requiring defendants to pay judgment interest in tort actions. Where the
patiies settle an appeal of a verdict, the Service has been successful in convincing the
cOUlis that a portion of the proceeds should be allocated to such interest. Delaney, 99
F.3d 20 (1st Cir. 1996), affg T.C. Memo. 1995-378.
NOTE: The comments in this section conceming information sources must be used
within the guidelines for compliance initiative projects. Additionally, the requirements
for third party contacts and third patty summonses outlined in RRA 98 must be followed.
[83] IdentifYing taxpayers who have received large taxable lawsuit settlements can be a
difficult process because a Form 1099 is not usually issued to the plaintiff. Most ofthe
retums to be examined would not normally be selected through regular classification. The
following sources may be used to identifY large taxable lawsuit settlements.
[84] One readily available source of information is local newspaper articles. Large
punitive damage verdicts generally make headlines. A coordinator can be responsible for
reviewing and maintaining interesting newspaper articles.
[85] This is an excellent source of identifYing taxpayers that have gone to court and had a
jury verdict. This does not identifY individuals who settle prior to a jury verdict.
[86] Detetmine where civil lawsuits are originally filed in your jurisdiction. In many
states cases are filed with the circuit clerk's civil division at the county cOUlihouse where
the lawsuit originates. There may be tens of thousands of civil cases filed in one year.
Only a small portion of these cases will be punitive damage cases. IdentifYing punitive
damage cases from this population can be a difficult process. Some of the techniques
used to identifY these cases include the following:
1. Scan the style of the case (plaintiff versus defendant) at
each courthouse. Most of the circuit clerks' offices will be
computerized, but some have hand-written records.
2. IdentifY insurance companies and finance companies who are
defendants in the cases. These are typically the types of
companies being sued for punitive damages.
3. Record the case file number.
4. Review the case file. Most of the cases are settled out of
cOUli and dismissed with prejudice. This means the case has

received final settlement and cannot be further litigated.
Typically the dollar amount of the settlement is not noted in
the file ifthe case is settled out of court. Use a worksheet
(see Appendix A for a sample) to gather pertinent information
from the civil case file. Scanning the file is one of the
most important techniques to become familiar with the type of
lawsuit filed. Suits which seem to have non-physical damages
(fraud, negligence, misrepresentation, etc.) are to be given
5. Review cases which are large in size. This tends to indicate
that the lawsuit was in process for an extended period of
time, and this could be an indication of a large settlement.
[87] In some states it may not be necessary to manually research the courthouse as
described above. Detelmine if your state has a centralized agency for recording all
lawsuits filed. In some states information is sent to an Administrative Office of Courts (a
state agency) on a monthly basis. This state agency should have a compiled list of the
cases filed in counties having a computerized system. The list may provide information
such as the case number, style (plaintiff versus defendant), type of case, date settled, and
amount of damages awarded.
[88] Once it has been determined that your state has a compiled listing of all civil cases,
obtain the magnetic tape of the list for all open exam years. There may be a charge for
this magnetic tape. The computer audit specialist (CAS) in your district can then
manipulate the data on the tape to certain specifications. For example, the CAS could
make a list of all civil cases that were settled by jury with specific dollar amounts
designated as compensatory and punitive. In addition, the list could be sorted into
geographic areas to fit post of duty locations. This POD data can then be reviewed for
cases with exam potential. Specific comihouse files could be reviewed if deemed
[89] This same computerized data just discussed can be used to identify settlement
payors. Review the database to select those companies that appear as defendants most
often. Insurance companies are usually the defendants in these cases and al'e a prime
source of information for lawsuits or payments made in lieu of a lawsuit. A contact with
the insurance company's legal depaliment should be made to establish communication
with the company. At that time you may explain the possible tax consequences of the
payments and what information you need. Request that they provide you with the
[90] Third party letters can be issued to the settlement payors requesting records needed
to begin examinations (see Appendix B for sample attachment to third party letters).
However, because of legal reasons, many insurance companies will require that you issue
a summons to them before they release any information to you. Whether you are issuing a
third pal1y letter or a summons, the following information should be requested:
1. Copies of the complaint,

2. Copies of settlement agreements and/or waivers,
3. Copies of front and back of checks,
4. Addresses of the plaintiffs, and
5. Social Security Numbers of the plaintiffs.
[91] When issuing a summons, it is recommended that you request assistance from the
company's legal department in structuring your request for information. This enables you
to obtain the information needed while minimizing their effOlis.
[92] It should be noted that the payors generally will not have a disbursement schedule. It
is standard practice for payors to disburse the gross amount of the settlement to the
plaintiff's attorney, who then disburses the money to his or her client(s). Therefore, the
disbursement schedule can best be obtained from the taxpayer (plaintiff). This
information may also be available fi'om the plaintiff's attorney. Generally, this
infOlmation would not be protected by the attorney-client privilege, but consult with the
appropriate Office of Chief Counsel if the facts and circumstances warrant pursuing this
action. Use of settlement payors has advantages in that the correct person can be easily
found. In addition, you know the amount of the payment and the date it was made.
[93] See Chapter 5, Third Patiy Contacts and Summons Information, for finiher
[94] The State Department of Insurance may have a complaint file on insurance
companies. These files may be reviewed for any additional leads on punitive damage
[95] The State Supreme Couli Library records all the cases that the State Supreme Court
has heard. Many of the large awards by jury are appealed to the State Supreme Court.
This reference can be used to make sure that no large cases are omitted fium possible
exam consideration.
NOTE: The following information concerning third party contacts and summons should
be read in conjunction with the provisions ofthe 1998 RRA in IRC sections 7602 and
7609. These provisions require taxpayer notice in many cases prior to the commencement
of third patiy contacts and new notice requirements for summons issued to third parties.
In addition, compliance Initiative Project (CIP) guidelines should be followed.
[96] Third parties may be potential sources of a variety of information. As indicated
earlier in this guide, the Service may be seeking information about the very existence of
lawsuit settlements. Moreover, even if aware of the existence of a settlement, the Service
may need to contact insurance companies or plaintiffs' attorneys to identify the specific
recipients, and/or determine the specific amounts disbursed to each of the recipients in

the settlement. The various devices for obtaining such information from third parties are
noted below.
[97] Examiners should initially attempt to secure needed information from the defendant
companies (mainly insurance companies) by orally requesting the companies to provide
the information voluntarily. If a company declines to produce the infOlmation in response
to an oral request, examiners should attempt to obtain the information through the use of
a third party request. Either the third party letter or a summons can be used both to
request information with respect to a specific taxpayer or to request information on
lawsuit settlement payments in general.
[98] In a situation where a third party letter is issued to an insurance company, ask the
insurance company's attorney to review the third party letter. Discuss the third party
request, pointing out that the letter is issued under the same Code section which
authorizes issuance of a summons (IRC section 7602). Where third party requests (either
oral or written) do not pertain to a specific taxpayer, they are not subject to the same
statutory control as a third party surmnons. However, in instances where the third party
letter pertains to a specific taxpayer, IRC section 7602(c), as revised by the RRA, may
apply to require that notice to the taxpayer be provided before the letter can be issued.
[99] The Service is not responsible for any costs incurred in responding to a third-party
letter. Ask the insurance company's attorney to review the confidentiality clause in the
settlement closing agreement, if applicable. If there is a confidentiality clause, it often
does not restrict the release of the facts of the case to the Service. Even where it does
restrict release of the facts, the Service may legally be entitled to the infOlmation, as IRC
section 7602 authorizes the Service to obtain any information that may be relevant to the
determination and collection of a tax liability.
[100] The company may respond to the third party letter; however, some companies will
require a summons.
[101] The manager must approve the issuance ofa summons. Form 1334, Requisition for
Equipment, Supplies or Services, has to be submitted for approval. An estimate of the
cost must be included on Form 1334. Ask the insurance company's attorney for an
estimate ofthe costs. Use Form 6863, Invoice and Authorization for Payment of
Administrative Summons Expense, to explain to the insurance company's attomeys the
amounts the Service will reimburse. Once the requested information is received, the
invoice should be submitted with a copy of the approved Form 1334, Form 6863, and a
copy of the front page of the summons to the appropriate office for payment. These
procedures may vary from location to location. In addition, discuss the prospective
summons with the insurance company's attorney to attempt to detelmine whether the
insurance company will honor a summons mailed to them, and the attorney's response
should be documented in the case file.
[102] Moreover, the summons should be carefully drafted to specify the information
being sought. Certain procedures differ depending on whether the summons is issued
with respect to a known taxpayer, specific taxpayers, or an unknown taxpayer. Where the
taxpayer is known, he or she is required to be given notice of a summons issued to a third
party, such as an insurance company, under section 7609 as amended by the RRA. This
notice must be provided within 3 days of service of the summons on the third party.

Moreover, where a summons is issued to a third party for information on more than one
taxpayer, a separate summons must be issued with respect to each taxpayer. Where the
specific taxpayer is not known, the requirements set forth below under "John Doe"
summons are applicable. Be sure the insurance company's attorney understands what
information you need because the Service is legally required to pay for the information,
even ifyou cannot use it.
[103] Follow up with the insurance company attorney after he or she receives the
summons. Discuss items on the information request. Some companies do not want to
release Social Security Numbers and other policy information because of privacy
concems. If the insurance company's attomey has a problem with any item, look for
altemative sources to get your information. For instance, Social Security Numbers can be
obtained through Integrated Data Retrieval System (IDRS) research.
[104] Set a response date. The Manual provides that 23 to 26 days should be allowed for
responding to a third party summons involving an identified taxpayer. This period cannot
be extended unless the summoned party is unable to appear. Follow up evety couple of
weeks to see ifthere are problems or concerns.
"John Doe" Summons
[105] In certain circumstances you may be faced with the situation of considering the use
of a "John Doe" summons. This is the only means of serving a summons where
information is sought with respect to one or more unknown (nonspecific) taxpayers. IRC
section 7609(f) defines a "John Doe" summons as ,,* * * any summons which does not
identifY the person with respect to whose liability the summons is issued." The Code
requires the Service to obtain court approval to serve a "John Doe" summons. Moreover,
the Code requires the Service to show the court that the following conditions are met:
1. The summons relates to an investigation of a particular
person or an ascertainable group or class of persons,
2. There is a reasonable basis for believing that such persons
or group or class of persons may fail or may have failed to
comply with any provisions of the Intemal Revenue law; and
3. The information sought to be obtained from the examination of
the records (and the identity of the person or persons with
respect to whose liability the summons is issued) is not
readily available from other sources.
[106] Due to these restrictions on serving a "John Doe" summons, this type of summons
is only appropriate in limited circumstances. The appropriate Office of Chief Counsel
must be involved at the very beginning of any plans to use a "John Doe" summons.
Always consult the IRM when considering a "John Doe" summons. Request only
information on cases for which settlement payments have been made, that is, ask the
company to note which cases are on appeal.
Third-Party Summonses
[107] IRC section 7609 as revised by RRA 98 requires notice procedures for issuance of
a summons to all third parties.

Attorney-Client Privilege
[108] It is standard practice for the insurance company (payor) to disburse the gross
amount of the settlement to the plaintiffs attorney, who then disburses the money to his
or her client(s). A third party letter can be issued to the plaintiffs attorney in an effort to
obtain the other names, and the amounts involved, in the settlement payment. Often, the
attorney will refuse to respond to the third party letter. If so, it is not recommended that a
summons be issued to the plaintiffs attorneys for disbursement information relevant to
the settlement due to the potential for protracted litigation over claims of attorney-client
privilege, which some attorneys may give as the reason for denying the requests for
information. Although attorney-client privilege is a valid basis for not providing some
requested infOlmation, fee an'angements usually fall outside the scope of the privilege.
Such infOlmation ordinarily reveals no confidential professional communication between
attorney and client. Determining whether this is true in a specific case requires
coordination with the appropriate Office of Chief Counsel.
[109] Moreover, due to the possibility oftime-consuming litigation, it is recommended
that all other means be exhausted in securing the disbursement information. Contact each
plaintiff (taxpayer) to determine the amount paid by the insurance company and then
disbursed through the attomey. Review the MSSP audit techniques guide on Attomeys
for more information conceming attomey-client privilege.
1. Refer to IRM on the following:
a. The defmitions of specific terms relative to the summons and
its issuance;
b. The use and enforcement of a summons; and
c. The restrictions on issuance of third party summons.
2. See IRC sections 7602, 7203, and 7604.
3. MSSP audit techniques guide on Attorneys.
[110] An examination case file is set up for individual taxpayers when a determination is
made on which lawsuits to pursue. The case file should include information needed to
conduct the examination.
[111] There are usually three ways to secure the taxpayer's Social Security Number
(SSN). If third party contacts were made, then the SSNs and addresses of these taxpayers
will have been secured through these requests. Another method is to use Corporate Files
on Line (CFOL) commands to obtain SSNs. If the examiner is still unable to get aSSN
through these techniques, a more thorough review of the case file at the courthouse may
reveal additional leads. The case file may have a SSN that was overlooked during the
initial gathering of information or it may provide another address to use in the IDRS
[112] Use CFOL commands to determine if the plaintifffiled a tax retum and to obtain a

copy of the return. Look at the copy of the return to detennine if the lawsuit proceeds
were included in income. If the plaintiff did not include the lawsuit proceeds in income,
an examination should commence. Follow the usual procedures to strut an examination. If
no return was filed, follow delinquent return procedures.
[113] The scope ofthe examination may be limited to the lawsuit proceeds issue.
However, the scope should be expanded in cases where other issues need to be addressed
using customary examination criteria. Sufficient steps should be taken to thoroughly
develop the facts of each case to determine the factual basis of each settlement.
1. Once a constructed file, which includes the necessary IDRS
research, is received by the examiner, he or she will contact
the taxpayer to set up the initial appointment. The
appointment letter to be used will depend on whether the
taxpayer has filed a tax return or not. The appointment
letter should include a document request including the items
shown in Appendix C. NOTE: This step in the examination
process can be done by group clerks or management aides. Due
to the nature of the issues involved, and the fact that most
of the taxpayers involved are wage earners, most of these
examinations will probably be held in the office. However,
there are instances that would require field visits. For
example, the taxpayer has a business that also requires
2. The most important step of the examination is the development
of the facts. The case file should include, at minimum, the
original complaint and pleadings, the settlement agreement or
release, the disbursement schedule or a clear statement of
how the funds were disbursed, and a copy of the agreement
relating to the attomey's fee arrangement. These documents
are critical in the development of the facts of the case and
are vital to Counsel ifthe case should go to COUlt. In
addition, because of the provision in IRC section 7491
concerning the potential for shifting the burden of proof to
the govermnent when taxpayers reasonably cooperate with the
IRS, examiners should carefully document the level of
cooperation taxpayers demonstrated during the audit process.
3. The next critical step in the examination is to detennine the
allocation of lawsuit proceeds between punitive and
compensatory damages. If the proceeds were received as a
result of a litigated case, the amount of punitive and
compensatory damages is usually made clear in the court

documents, and there may be no further work to be done in
making the allocation. However, it is more difficult to make
that determination for cases settled out of court. The
settlement agreement does not usually make a distinction
between the punitive and compensatory damages awarded. These
settlement agreements are usually silent as to the types of
damages awarded, or they state that all of the damages
awarded are "compensatory." Therefore, it is essential that
all the facts surrounding the lawsuit be determined and
documented. The allocation between compensatory and punitive
damages must be made based on the facts of each case. In
making this determination, the following items should be
a. The intent of the payor in making the payment to the
plaintiff. Why did the payor settle? For what was the
payor paying?
b. The nature ofthe claim underlying the plaintiffs
award. What was the reason for the suit?
c. The negotiations between the plaintiff and defendant.
Review the case file. Was there a meeting of the minds
by the parties?
d. The actual amount of money it would take to make the
plaintiff whole. Did the plaintiff make insurance
premium payments or was the plaintiffto receive a
certain amount of insurance proceeds? The settlement
amount that the plaintiff receives to reimburse him or
her for these types of costs are usually compensatory.
e. If the plaintiff claims to have suffered from mental
pain and anguish, determine if the plaintiff received
medical treatment for the mental pain and anguish. If
so, does he or she have verification ofthe amount spent
for this treatment? Can he or she show that the
treatment is directly related to the lawsuit case? In
other words, the plaintiff must show that he or she was
being made "whole" from the total amount of the
settlement received in order for the whole amount of the
settlement to be non-taxable. The taxpayer bears the
burden at the audit stage of showing that the damages
received are excludable from gross income under IRC
section 104(a)(2), (although that burden may shift to
the government if the issue reaches litigation and the

taxpayer satisfies the requirements ofIRC section
NOTE: The most difficult issue in these cases is the
determination ofthe punitive and compensatOly damages
when there is a settlement agreement. Normally, it is
reasonable for some portion to be allocated to
compensatory damages in most cases. Develop the facts
carefully and objectively for each case.
4. Determine ifthe taxpayer received any client advances from
the attorney. If the taxpayer received advances from the
attorney, ensure that the settlement proceeds were not
reduced by these advances. Also, determine if the advances
were elTOneously characterized as legal fees that would
provide the taxpayer with a deduction for personal expenses.
5. Once a determination is made regarding the allocation of the
punitive and compensatory damages, the punitive portion of
the damages is considered taxable. It is the Service's
position that the taxpayer is to be taxed on the full amount
ofthe punitive damages before the attorney is paid any fees.
In other words, the taxpayer cannot report the "net" punitive
proceeds received. Note: this is an issue that has been
litigated continuously.
The taxpayer must include in income the gross amount of the
award deemed to be taxable. A deduction is allowed for the
legal fees and court costs that are related to the taxable
portion ofthe proceeds. The legal fees and court costs are
allowed as a miscellaneous itemized deduction subject to the
2-percent AGI limitation on Schedule A. The deductible fees
and costs are detennined by using the ratio of taxable
proceeds to total proceeds and multiplying the total fees and
costs by this ratio. The following is an example.
Tota1lawsuit proceeds received $100,000
Taxable lawsuit proceeds(80% taxable) 80,000
Legal fees and comt costs 52,000
Total fees and costs $52,000

Taxable Ratio (80,00011 00,000) X .80
Deductible fees and costs 1*1 $41,600 1*1


1*1 subject to 2% AGI limit
NOTE: When allowing this as a deduction, consideration should
also be given to any other itemized deductions to which the
taxpayer may be entitled but did not deduct on the original
return because their itemized deductions were less than the
standard deduction amount.
6. AMT must be considered because of the allowance of the
miscellaneous itemized deduction. AMT usually becomes due
when there is a large amount of miscellaneous itemized
deductions. Miscellaneous itemized deductions subject to the
2-percent AGI limitation are a tax preference item for
alternative minimum tax purposes. The RepOlt Generating
Software (RGS) program for producing Revenue Agent reports
will automatically compute this tax.
7. The following issues should also be considered when making
the adjustment to income for the lawsuit proceeds:
a. Earned Income Credit -- If the taxpayer claimed the
Earned Income Credit on the original filed return, then
it may have to be recaptured as a result of the increase
in income from the lawsuit.
b. Social Security Income -- If the taxpayer received any
type of Social Security income, the taxable pOltion of
this income may be increased due to the increase in
income from the lawsuit.
c. Exemption -- The personal and dependent exemptions taken
by the taxpayer may be limited or phased out due to the
increase in income from ,the lawsuit. This is an
automatic adjustment and will be computed by the RGS
program for producing Revenue Agent repOlts.
d. Itemized Deductions -- Itemized deductions taken by the

taxpayer may be limited or phased out due to the
increase in income from the lawsuit settlement. This is
another automatic adjustment that will be computed by
the RGS program for producing Revenue Agent reports.
e. Rental Real Estate Losses -- Rental Real Estate Losses
could be limited due to the increase in modified AGI. If
the modified AGI exceeds the threshold, then passive
losses will be limited. The RGS program for producing
the Revenue Agent reports will not automatically compute
the allowable passive losses.
[114] Examiners are responsible for considering the application of penalties in all cases
under examination. Many lawsuit settlement cases involve taxpayers who normally do
not have to file returns except for the settlement proceeds received. However, returns are
still not filed in some situations because the taxpayers and their representatives concluded
the proceeds are not taxable. For retums that are not filed, the following penalties should
be considered:
1. Failure to file penalty (IRC section 6651(a)(1»
2. Estimated tax penalty (For Individuals: IRC section 6654)
3. Fraud or negligence (pre-1989 only: IRC section 6653)
4. Fraudulent failure to file (Post 1988: IRC section 6651(f)
[115] The accuracy-related penalty applies only where a return is filed and is not
applicable to substitutes for retums filed under authority ofIRC section 6020(b). These
provisions apply to all retums due to be filed after December 31, 1989, without regard to
extensions filed.
[116] There is no reasonable cause exception to the IRC section 6654 penalty for
underpayment of estimated tax by an individual. The penalties apply unless the taxpayer
meets certain specified statutory exceptions. However, in the case of an individual, IRC
section 6654(e)(3) provides that the Service may waive the penalty if the Service
determines it would be inequitable, due to casualty, disaster, or other unusual
circumstances. The Service may also waive the penalty if the taxpayer has retired or
become disabled during the taxable year and his or her underpayment was due to
reasonable cause and not to willful neglect.
[117] The failure to pay penalty applies to original and amended returns filed by the
taxpayer. With regard to returns due prior to June 30, 1996, the failure to pay penalty
does not apply when the taxpayer does not file a return or if the rerum is filed under IRC
section 6020(b) substitute for return procedures. With regard to retums due after June 30,
1996, the Service may impose the failure to pay penalties where the taxpayer fails to file
a retum and a substitute return is prepared by the Service under IRC section 6020(b). IRC

section 6651 (g).
[118] Lawsuit settlement cases usually result in significant adjustments to income. As in
other cases where there are large amounts of unreported income, the accuracy-related
penalty and fraud penalties must be considered. Factors to consider in determining
whether penalties are warranted include:
1. Did the lawsuit settlement recipient adequately disclose all
pertinent facts of his or her case to his or her attorney?
2. What advice, if any, did his or her attorney provide
regarding the taxability of the settlement amount? and
3. Should the taxpayer have questioned the advice of his or her
attorney regarding the taxability of the payment?
[119] All the facts and circumstances in each case should be considered before making a
determination regarding penalties. If the taxpayer received interest income from the
settlement and did not report it, more consideration should be given to assessing the
accuracy-related penalty on the interest income issue.
[120] If penalties are recommended, the examiner's workpapers should contain comments
regarding the examiner's reasons for asserting penalties. If reasonable cause was available
and considered, the examiner's workpapers should explain why it was or was not
[121] IRC section 6041 (a) generally requires all persons engaged in a trade or business
and making payment in the course of such trade or business to another person of fixed or
determinable gains, profits, and income of $600 or more in a calendar year to file an
information return with the Service. IRC section 6041 (d) provides that each person
required to make the return described in IRC section 6041(a) shall furnish to each person
for whom a return is required a payee statement.
[122] Treas. Reg. section 1.6041-1(c) states that income is fIXed when it is paid in
amounts definitely predetenuined. Income is detetminable whenever there is a basis of
calculation by which the amount to be paid may be ascetiained. The payor is required to
determine whether payments are taxable and need to be reported. The Instructions for
Forms 1099, 1098,5498 and W-2G provides instructions on the items to be reported.
[123] In lawsuit settlements, the person with the obligation to report payments to the
plaintiff will generally be the defendant or its insurer rather the plaintiff's attorney. In
addition, the defendant or its insurer will also generally be responsible for reporting
payments to the plaintiff's attorney.
[124] Box 3 of Form 1099-MISC is used to repoti other income that is not repOliable in
one of the other boxes on the form. Generally, all punitive damages (even if they relate to
physical injury or physical sickness), any damages for non-physical injuries or sickness,
liquidated damages received under the Age Discrimination in Employment Act of 1967,
and any other taxable damages are required to be reported in box 3. Generally, all
compensatOlY damages for non- physical injuries or sickness (for example, emotional

distress) arising from employment discrimination or defamation are reportable in box 3.
However, if a taxpayer receives an award of back pay that constitutes wages, it generally
would be repOliable on Form W-2, not Form 1099-MISC.
[125] The following damages (other than punitive damages) are not reportable in box 3 of
Form 1099-MISC:
I. Damages received on account of personal physical injuries or
physical sickness.
2. Damages that do not exceed the amount paid for medical care
for emotional distress; or
3. Damages received on account of non-physical injuries (for
example, emotional distress) under a written binding
agreement, court decree, or mediation award in effect on or
issued by September 13, 1995.
[126] Damages received on account of emotional distress due to non-physical injmy or
sickness, including physical symptoms such as insomnia, headaches, and stomach
disorders, are reportable unless described in 2 or 3 above. However, damages received on
account of emotional distress due to PHYSICAL injuries or physical sickness are NOT
[127] The amount of damages reflected on the Form 1099-MISC is not reduced by
attorney's fees. For example, a defendant settles a plaintiffs claim for emotional distress
from non-physical injuries by writing a $100,000 check naming the plaintiff and her
attomey as joint payees. The attorney retains $40,000 in fees for services rendered and
remits the remaining $60,000 to the plaintiff. The amount of damages repOliable with
respect to the plaintiff on Form 1099-MISC is $100,000.
[128] Fees paid to an attorney of$600 or more, paid in the course of the payor's trade or
business, are repOliable in box 7 of Form 1099-MISC. However, for 1998 and later years,
if the payor pays an attorney in the course of its trade or business for legal services and
the attorney's fee cannot be detenuined, the total amount paid to the attorney (gross
proceeds) must be repOlied in box 13 with Code A.
[129] For example, an insurance company pays a plaintiff's attorney $100,000 to settle a
plaintiff's claims for damages that are excludable from income under IRC
section104(a)(2). The attorney's fee cannot be determined by the insurance company.
Therefore, the insmance company must report $100,000 in box 13 of Form 1099-MISC
with Code A. If the insurance company knows that the attorney's fee is, for example,
$34,000, the insurance company must repOli $34,000 in box 7 and nothing in box 13.
[130] These rules apply whether or not the legal services are provided to the payor, and
whether or not the attorney is the exclusive payee (for example, the attorney's and
claimant's names on one check). However, these rules do not apply to profits distributed
by a partnership to its paliners that are reportable on Schedule K-1 (Form 1065), Partner's
Share of Income, Credits, Deductions, etc., or to wages paid to attorneys that are
reportable on Form W-2, Wage and Tax Statement. The telm "attorney" includes a law
firm or other provider oflegal services.

[131] In addition, the exemption from reporting payments made to corporations no longer
applies to payments for legal services. Therefore, for 1998 and later years, attorney fees
(in box 7) or gross proceeds (in box 13), as described above, paid to corporations
providing legal services are reportable.
Bill'ford v. United States, 642 F. Supp. 635 (N.D. Ala. 1986).
[132] The district court rejected Rev. Rul. 84-108 and concluded that Alabama wrongful
death proceeds are excludable from gross income.
O'Gilvie v. United States, (1996 S. Ct.) 519 U.S. 79,117 S. Ct. 452; 96-2 U.S.T.C.
paragraph 50,664; 78 AFTR 2d 7454.
[133] The Supreme Court mled that all non-compensatory punitive damages are taxable.
Commissioner v. Schleier, (1995 S. Ct.) 515 U.S. 323, 75 AFTR 2d 95- 2675, 115 S. Ct.
[134] The Supreme Court mled that payments received under the federal statute
outlawing age discrimination are 100-percent taxable. The ADEA does not provide for
recovery of tort-like compensatory damages and the proceeds were not received on
account of any personal injury.
[135] Schleier outlined the two-part test that must be met in order to exclude damages
under IRC section 104(a)(2): 1) the underlying cause of action giving rise to the recovery
must be based on tort or tort-type rights; and 2) the damages must "have been received on
account of personal injill'ies or sickness."
United States v. Burke, (1992 S. Ct.) 504 U.S. 229,112 S. Ct. 1867,92-1 U.S.T.C.
paragraph 50,254.
[136] The Supreme Court ruled that back pay received in settlement of claims under Title
VII of the Civil Rights Act of 1964, before the 1991 amendments, were not excludable
under IRC section 104(a)(2).
[137] The Burke case includes a very good discussion on tort injuries, physical, nonphysical, etc.
[138] The following is a list of other cases that deal with various discrimination claims.
All of these are prior to the Supreme Court lu1ings of Burke and/or Schleier which
contain our present authority for these types of cases. While these cases fluctuate on the
question of taxability or exclusion (because they are prior to the clear guidance of Burke
and Schleier) they contain some good discussions conceming the questions of defining
torts and personal injuries, physical and non-physical.
1. Downey v. Commissioner, (1994 7th Cir.) 94-2 U.S.T.C. paragraph
50,441; 74 AFTR 2d 6015. In Schleier, the Supreme Court agreed
with the discussion relating to torts and the court's holding on
the exclusion issue.
2. Johnson-Waters v. Commissioner (1993 Tax Court) 66 T.C.M. 252;
T.C. Memo. 1993-333. This case includes good comments about the

taxpayer having the burden of proof and "self serving testimony"
concerning an out of court settlement allocation. The IRS
reallocation to back pay with a small amount for tort-mental
distress was upheld. Note, however, the court's holding that the
back pay portion recovered under 42 U.S.C. section 1981 is taxable
is inconsistent with the rationale underlying Rev. Rul. 93-88.
3. Stocks v. Commissioner, (1992 Tax Court) 98 T.C. 1. This case
involves an employment breach of contract and race discrimination
issue. No actual lawsuit was filed, but claims were "settled" with
an employment termination agreement. The Tax Court looked at the
payor's intent in allocating 5/6 of the settlement to the contract
and 1/6 of the settlement to the discrimination claim. The
evidence showed that the employer was aware of the possibility of
the discrimination lawsuit. Their intent was that the payment
would settle the potential discrimination lawsuit along with the
breach of contract issue. The employer admitted it would not have
made the payment unless the taxpayer released them from any
discrimination claim as well as the contract claim.
4. Pistillo v. Commissioner, (1989 Tax Court) 57 T.C.M. 874; T.C.
Memo. 1989-329. The Tax Court found that an ADEA back pay
settlement was 100-percent taxable. This decision was later
reversed by the 6th Circuit, but contains good comments on several
areas of interest including damages and settlements arising from
employment contracts, back pay, etc., not excludable under IRC
section 104(a)(2). The taxpayer argued that his employer's failure
to withhold any federal income tax or social security taxes fi'om
the settlement demonstrated its intent to compensate for personal
injury. The taxpayer further argued that because the District
Court, his attomey, and the IRS stated that the settlement
payment was not income, the amount is excludable.
5. Bentv. Commissioner, (1987 3d Cir.) 88-1 U.S.T.C. paragraph 9101;
61 AFTR2d 301; 835 F.2d 67. The court ruled that the settlement
amount received for violation of the taxpayer's rights to fi'eedom
of speech was excludable under IRC section 104(a)(2). If decided
after Schleier, taxpayer would fail the second test for exclusion.
See Kightlinger v. Commissioner, T.C. Memo. 1998-357, infra.
6. Metzger v. Commissioner (1987 Tax Court) 88 T.C. 834. This was a
case involving employment breach of contract and discrimination by
sex and national origin. The continued vitality of this case is
questionable in light of Burke and Schleier. The Service does not
believe that economic damages such as wages can be a measure of a
personal injUlY. Such damages are distinct from personal injury

[139] The following cases are Employment related and most deal with allocation issues
and questions of taxable versus excludable.
1. Bames v. Commissioner, (1997) T.C. Memo. 1997-25.
This case involved an out-Of-COUlt settlement received due to
wrongful discharge with mental distress. The Tax COUlt allocated
50/50 to mental distress and punitive damages because the mental
distress manifested as pre-cancerous tmnors.
2. Bagley v. Commissioner, (1995) 105 T.C. 396, aff'd, 121 F.3d 393
(8th Cir. 1997).
This case involved claims for tOltious interference with CUlTent
and future employment, libel, and invasion of privacy. The trial
resulted in a jury verdict that was appealed. A settlement
agreement was reached prior to the new trial. This settlement
agreement allocated the entire award to compensatory. The Tax
Court looked to the facts ofthe case, including the trial
determinations and the negotiations for settlement. The Tax
Court detelmined that a portion should be allocated to punitive,
even though the payor stated in negotiations that they would not
agree to pay punitive damages. The Tax Comt determined that
both patties considered the clear possibility of punitive
damages being recovered. The Tax Comt pointed out that the
taxpayer's attorney became aware of the potential for taxability
of punitive during the negotiations.
3. Glatthorn v. United States, (1993) 93-1 U.S.T.C. paragraph 50,338;
71 AFTR 2d 1878; 818 F. Supp. 1548 (District Ct -- Florida).
This case involved a breach of contract claim. The plaintiff
received an out-of-court settlement with no settlement document.
The court allocated 50 percent of the proceeds to the breach of
contract issue and 50 percent as compensatory. When making this
decision, the district comt relied heavily upon the following:
The taxpayer offered to settle for $45,000. The defendants
did not accept his offer until after the court had refused
to dismiss the tort claims. Shortly after that time, the
defendants accepted the settlement. The district court said
that the defendants (attorneys, themselves) would not have
settled a $47,000 breach of contract case for $45,000 in
the early stages of the lawsuit -- so the settlement had to

also relate to the tort claims.
The taxpayer argued that at least 9/11 of the settlement is nontaxable, as 9 of the II counts sounded in tmi. The district
court refused to apply this mathematical formula, particularly
since many ofthe tort counts stated the same cause against
different defendants.
4. Miller v. Commissioner, (1993) 65 T.C.M. 1884; T.C. Memo. 1993-49.
This was a defamation case against a former employer. There were
two separate lawsuits. One involved ajury verdict and the other
suit was not tried. A settlement was reached which covered both
lawsuits. The settlement agreement did not allocate the proceeds
between compensatory and punitive damages.
The question presented to the Tax Court was one of allocation
between compensatory and punitive. The Tax Court lUled that the
verdict by the jury was the best indicator of the payor's intent
and the best measure of how the settlement should be allocated.
Miller includes good analyses and case cites pertaining to
settlement allocations. It also includes comments conceming the
importance of the nature of the claim versus the validity of the
claim in determining the allocation.
5. Mitchell v. Commissioner (1990) 60 T.C.M. 1368; T.C. Memo. 1990617.
The taxpayer had prepared a settlement document stating that
most of the damages were for libel and slander. The Tax Court
determined that all damages related to the employment contract.
The taxpayer's employer viewed the libel/slander suit as a
"nuisance" suit and gave it no weight in determining the
settlement payments.
6. McKim v. Commissioner (1980) 40 T.C.M 9; T.C. Memo. 1980-93.
The taxpayer sued his fOlmer employer after being terminated.
His first claim was for unpaid sales commissions and other
unpaid job related amounts, such as fringe benefits and
unreimbursed expenses. He also brought a claim for suffering,
emotional distress and for punitive damages. The court allocated
the whole settlement to taxable wages. The court looked to
testimony from the taxpayer's employer to detelmme which claim
it had intended to settle. The employer stated it did not

believe it had any exposure to liability for any claims for
personal injUly damages and that these claims did not figure
into the settlement amount.
In conclusion, the Tax Court stated that even if it found that
the employer had intended to pay some on each of the taxpayer's
claims, the allocation to personal injury would have been
minimal. The Tax Court totaled up all the amounts requested in
each count (taxpayer had assigned monetary amount to each claim)
and determined that the percentage of the personal injury amount
requested would only be 15 percent.

7. Seay v. Commissioner (1972) 58 T.C. 32.
This case involved a breach of contract claim. The taxpayer was
allowed to exclude a portion of the payment under IRC section
104(a)(2) for personal injuries. The taxpayer had suffered
personal embarrassment, mental and physical strain, and injUly
to health and personal reputation.
The government argued that the taxpayer had not proven that his
claim for personal injuries was valid or that he had actually
inculTed such injuries. The cOUlt gives an in-depth explanation
concerning the fact that the taxpayer does not have to prove the
validity of the claim. The taxpayer only has to prove that there
was a personal injury claim and that the claim was included in
the settlement payment. In this case, the taxpayer was able to
show that the personal injury claim had been a part of the
negotiations for settlement and that the payor intended to make
payment in settlement ofthat claim.
8. Knuckles v. Commissioner (1965) 65-2 U.S.T.C. paragraph 9629; 16
AFTR2d 5515; 349 F.2d 610.
Tenth Circuit affirmed the Tax Court. The taxpayer was fired
from his executive position based on allegations that he
mismanaged the company's affairs. The taxpayer originally sued
for breach of contract with no mention ofpersonal injuries.
During settlement negotiations the taxpayer's attorney suggested
the payment be allocated to personal injuries in order to
minimize the tax effect. The taxpayer's employer refused to
allocate any damages to personal injury and admit to any
liability for personal injury. The taxpayer filed a subsequent
personal injury suit 9 months later. Both suits were dismissed
with the out-of-court settlement. The Service allocated all to
breach of contract (taxable). Taxpayer had allocated all to

personal injury (non-taxable). The Tax Court upheld the
Service's detennination and the Appeals Court affilmed. The
Appellate Court stated that the most important fact is "intent
of payor."
9. Abrahamsen v. United States, 44 Fed. Cl. 260 (1999) appeal pending,
No. 99-5136 (Fed. Cir.).
In this consolidated case, approximately 2,600 fonner employees
of IBM sought refunds of income and FICA taxes on the basis that
payments received under certain resource reduction programs were
excludable from gross income as personal injUly damages and
consequently were not wages. Noting that none of the plaintiffs
instituted a claim against IBM before executing releases and
receiving the payments, the cOUli doubted that they satisfied
the first test for exclusion. Even ifthey did satisfy that
test, the court concluded, the plaintiffs failed to satisfy the
second test that the payments were received "on account of
personal injuries."
On the FICA issue, the court reasoned that because the payments
were linked to salmy atld length of tenure, the payments were
consistent with the notion of wages.
1. Church v. Commissioner (1983) 80 T.C. 1104.
Case includes fOlmula for allocating legal fees between taxable
atld non-taxable portions of awards and settlement proceeds for
purposes ofIRC sections 212 and 265.
2. Alexanderv. Internal Revenue Service (1995) 96-1 U.S.T.C.
paragraph 50,011; 72 F.3d 938; (1st Cir.).
Great case on legal fees issue. Gross versus net, itemized
deductions, and AMT comments included. See also Bagley, 121 F.3d
393 (8th Cir. 1997); Baylin, 43 F.3d 1451 (Fed. Cir. 1995);
Coady, T.C. Memo. 1998-291, affd, 213 F.3d 1187 (9th Cir.
2000); Srivastava, T.C. Memo. 1998-362, rev'd, 86 AFTR2d
paragraph 2000-5104 (5th Cir. 2000); Sinyard, T.C. Memo.
1998-364; and Benci-Woodward, T.C. Memo. 1998-395, affd, 86
AFTR2d paragraph 2000-5102 (9th Cir. 2000).

1. Lane v. United States (1995) 95-2 U.S.T.C. paragraph 50,455, 76
AFTR2d 6085; 902 F. Supp. 1439 (Dist. Ct. Oklahoma).
This case involves a claim on an auto insurance policy for
uninsured motorists. Basically this is a punitive damage issue
case. Note, however, that under Oklahoma law, compensatory
damages awarded for insurance bad faith do not compensate for
any personal injury. Rather, they constitute in large part
compensation for the loss of the use of the contract damages,
and in lesser pmi, additional attomey's fees incurred as a
result ofthe insurer's failure to pay the claim in a timely
fashion. Thus, under Schleier, they are not excludable from
gross income. However, there are some good points in general
concerning suits against insurance companies.
2. Est. of Wesson v. United States (1995) 95-1 U.S.T.C. paragraph
50,186,75 AFTR2d 1540; 48 F.3d 894 (5th Cir.).
Punitive dmnage issue that involved bad faith against a life
insurance company is addressed in this case.
3. Hawkins v. United States (1994) 94-2 U.S.T.C. paragraph 50,386, 74
AFTR2d 5363; 30 F.3d 1077 (9th Cir.).
Punitive damage issue that involved breach of good faith and
fair dealing against Allstate Insurance Company is addressed in
this case. Contains a description of shifting Service position
on taxation of punitive damages.
1. Brabson v. United States (1996) 96-1 U.S.T.C. paragraph 50,038, 77
AFTR2d 572, 73 F.3d 1040 (10th Circuit), rev'g 859 F. Supp. 1360 (D.
Colo. 1994).
This case involves a personal injury claim. The family was
injured by a gas leak in their home. The only issue was the
question of whether the pre-judgment interest is excludable
under IRC section 104. The district COUli ruled that the
interest was not taxable but the Tenth Circuit reversed.
2. Robinson v. Commissioner (1994) 102 T.C. 116 (Tax COUli) (affirmed
on allocation by 5th Cir.).
The taxpayer's out of court settlement allocation was set aside
for tax pUl'Poses because the negotiations were not conducted in

an adversarial manner. The taxpayer was given the freedom to
allocate as he wanted in order to minimize the tax effect.
3. Eisler v. Commissioner (1973) 59 T.C. 634.
Eisler is often quoted in litigation cases. This case involved a
business deduction issue. The issue was whether taxpayer could
deduct the settlement payment and legal fees under IRC section
162 as a business expense or whether they were to be
The court looked to the strength ofthe parties' various claims
as perceived by their counsel in order to allocate a portion to
ordimuy and capital.
The case includes comments on doing the best you can with the
information you have.
4. LeFleurv. Commissioner, (1997) T.C. Memo. 1997-312.
LeFleur is an employment related case, but its particular
importance lies in the area of reallocation issues. In this case
the IRS successfully reallocated $800,000 from nontaxable
emotional distress claims to taxable contract/punitive damage
claims. (See Chapter 2 for additional infOlmation.)
5. Fabry v. Commissioner, 111 T.C. 305 (1998).

In Fabry, the Tax Court amplified its prior holdings on the
taxability of damages received for injmy to an individual's
business/professional reputation. The com1 rejected taxpayer's
argument that such injmy is, as a matter of law, a personal
injury for IRC section 104(a)(2) purposes. Instead, the com1
held, whether injury to one's business or professional
reputation constitutes a personal injury is a question of fact
to be resolved by consideration of all the facts and
circumstances. Because the taxpayer made no claim for personal
injmy in the underlying product liability action, the com1
concluded that the portion of the settlement proceeds allocable
to taxpayer's claim for injury to his business reputation was
not excludable from gross income.
6. Kightlinger v. Commissioner, T.C. Memo. 1998-357.

In Kightlinger, the court correctly interpreted Schleier and
held that loss of a job does not constitute a personal injury.

Also, the court concluded, the economic factors were not a
measure ofpersonal injmy; rather, they were the injury itself
that the taxpayer sustained. Further, the Tax Comi, in view of
all the contrary evidence in the record, rejected the district
court's holding that the suit was for personal injuries suffered
by the class members.
7. Greggv. Commissioner, T.C. Memo. 1999-10.
In Gregg, the court rejected the taxpayers' argument that
compensatory damages received for common law fraud and tortious
interference with business relationship were excludable from
gross income.
8. Remelt v. United States, 122 F.3d 204 (4th Cir. 1997); Mayberry
v. United States, 151 F.3d 855 (8th Cir. 1998); Dotson v. United
States, 87 F.3d 682 (5th Cir. 1996); and Gerbec v. United States,
164 F.3d 1015 (6th Cir. 1999).
A conflict among the circuits exist on whether payments received
in settlement of claims arising under ERISA qualifY for
exclusion under IRC section 104(a)(2). The Government's position
is that notwithstanding the subjective belief of the paliies
that the statute provided for tmi relief, the subsequent
detelmination ofthe Supreme Court that ERISA does not provide
tort remedies is controlling for tax purposes. Two circuits (and
two dissenters in the other circuits) agreed that taxpayers
failed to meet the first requirement for exclusion.
Notwithstanding the intercircuit conflict, the Solicitor General
disagreed with Service's recommendation that Supreme Court
review is walTanted. This disagreement is founded on the fact
that Congress, in 1996, amended IRC section 104(a)(2) to provide
that the exclusion applies to damages received for personal
physical injuries only. Because ERISA does not authorize the
recovelY of such damages, the administrative importance ofthe
income tax issue has diminished.
Appendix A

Sample Attachment to Letter
With respect to the settlements your company paid to the following
(the name ofyour state) residents:
List of Plaintiffs
Please provide the following information:
1) Plaintiffs address, phone number, and Social Security Number,
2) Copies ofthe complaints,
3) Copies ofthe settlement agreements and/or waivers,
4) Copies of front and back of the checks.
5) Copies of any records documenting correspondence between your
company and the plaintiffs with respect to negotiations affecting
the outcome ofthe cases.
Please notifY me as soon as possible if the requested information
will require a summons.
Appendix C
FORM 4564
[form omitted]
Excerpts from Legislative HistOlY of 1996 Amendment
5. ModifY exclusion of damages received on account of personal
injury or sickness (sec. 1605 of the bill and sec. 104(a)(2)
of the Code)
Present Law
Under present law, gross income does not include any
damages received (whether by suit or agreement and whether as
lump sums or as periodic payments) on account ofpersonal injury
or sickness (sec. 104(a)(2)).
The exclusion from gross income of damages received on
account ofpersonal injury or sickness specifically does not
apply to punitive damages received in connection with a case not
involving physical injury or sickness. Courts presently differ

as to whether the exclusion applies to punitive damages received
in connection with a case involving a physical injury or
physical sickness. 22 Certain States provide that, in the case
of claims under a wrongful death statue, only punitive damages
may be awarded.
Courts have interpreted the exclusion from gross income of
damages received on account ofpersonal injury or sickness
broadly in some cases to cover awards for personal injury that
do not relate to a physical injmy or sickness. For example,
some courts have held that the exclusion applies to damages in
cases involving certain forms of employment discrimination and
injury to reputation where there in no physical injury or
sickness. The damages received in these cases generally consists
of back pay and other awards intended to compensate the claimant
for lost wages or lost profits. The Supreme Comi recently held
that damages received could not be excluded from income. 23 In
light of the Supreme Court decision, the Internal Revenue
Service has suspended existing guidance on the tax treatment of
damages received on account of other forms of employment
Reasons for Change
Punitive damages are intended to punish the wrongdoer and
do not compensate the claimant for lost wages or pain and
suffering. Thus, they are a windfall to the taxpayer and
appropriately should be included in taxable income. Further,
including all punitive damages in taxable income provides a
bright-line standard which avoids prospective litigation on the
tax treatment of punitive damages received in connection with a
case involving a physical injury or physical sickness.
Damages received on a claim not involving a physical injury
or physical sickness are generally to compensate the claimant
for lost profits or lost wages that would otherwise be included
in taxable income. The confusion as to the tax treatment of
damages received in cases not involving physical injmy or
physical sickness has led to substantial litigation, including
two Supreme Court cases within the last four years. The taxation
of damages received in cases not involving a physical injury or
physical sickness should not depend on the type of claim made.

22 The Supreme comi recently agreed to decide whether punitive damages awarded in a

physical injury lawsuit are excludable from gross income. O'Gilvie v. U.S., 66F.3d 1550
(10th Cir. 1995), cert. granted, 64 U.S.L.W. 3639 (U.S. March 25, 1996)(No. 95-966).
Also, the Tax Court recently held that ifpunitive damages are not of a compensatory
nature, they are not excludable from income, regardless of whether the underlying claim
involved a physical injUly or physical sickness. Bagley v. Commissioner, 105 T.C. No.
27 (1995).
23 Schleier v. Commissioner, 115 S.Ct. 2159 (1995).

Code Section: Section 104 -- Damage Awards/SickPay; Section 61 -- Gross Income
Geographic Identifier: United States
Subject Area: Individual income taxation
Practice and procedure
Tax system administration issues
Index Tenns: damages
personal i'1iury damages
personal injury damages, age discrimination
personal injury damages, sex discrimination
gross income
Institutional Author: Internal Revenue Service



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