Tax aspects of personal injury awards.

A new law says punitive damages and nonphysical injury awards are taxable.

Congress has finally ended years of litigation concerning the taxability of punitive damages and damages for nonphysical injuries such as gender and age discrimination. The Small Business Job Protection Act (SBJPA) that President Clinton signed into law on August 20, 1996, includes rules regarding the Internal Revenue Code section 104 exclusion from income of awards received for injuries. Under the new provisions, punitive damages-- whether or not related to physical injury--cannot be excluded from gross income. Awards for nonphysical injuries are excludable only to the extent of amounts paid for medical care that are attributable to emotional distress. (A glossary appears on page 40.)

CPAs with clients involved in injury litigation need to be aware of how these awards are taxed. Accountants for companies involved in these lawsuits also need to be aware of how awards are taxed so they can withhold the appropriate taxes from the settlements they pay.

THE WAY IT WAS

To better understand the changes the SBJPA made and the situations to which they apply, it's important for CPAs to be aware of the confusion that led Congress to propose new rules, including some of the court decisions that highlighted the need for clarification.

Before IRC section 104(a)(2) was amended by the SBJPA, damages received as a result of personal injury or sickness were excluded from gross income. (Damages received is defined by regulations section 1.104.-1(c) as amounts received through prosecution of a legal suit or action based on tort or tort-type rights or through a settlement agreement entered into instead of filing suit.) This seemingly straight-forward provision has met with several Internal Revenue Service challenges in recent years involving awards for lost wages, punitive damages, damages to reputation and gender, race and age discrimination.

Similarly, the tax treatment of punitive damages for nonphysical injury was a matter of litigation until the Revenue Reconciliation Act of 1989. For taxable years ending after July 10, 1989, only punitive damages for personal injury recoveries involving physical injury or sickness were excludable from income.

One area where taxpayers had some success in excluding damages was gender discrimination. However, in United States v. Burke (92-1 USTC P50,254), the U.S. Supreme Court reversed the Sixth Circuit Court of Appeals, holding that amounts received for gender discrimination under Title VII could not be excluded under section 104(a)(2).