Wednesday, February 15, 2012

IRS eliminates tort test for exclusion of personal injury/sickness damages

Doeren Mayhew 
IRS eliminates tort test for exclusion of personal injury/sickness damages
Recent IRS regulations provide that damages received from a lawsuit or settlement as compensation for personal physical injuries or sickness may be excluded from gross income, even when they were not awarded in an action based on tort or tort-like injuries. The new guidance brings the IRS's official set of regulations up to speed with current law.

By statute, as amended in 1996, damages received "on account of personal physical injuries or physical sickness" are expressly excluded from taxable gross income. But courts have also applied a "tort test" that pre-dates the amendment in order to prevent taxpayers from wrongfully excluding damages awarded in breach of contract cases or other cases were the injury was not physical. For example, the U.S. Supreme Court found inUnited States v. Burke, 504 U.S. 229 (1992), that the award of retroactive wages withheld in violation of Title VII was not a tort-like personal injury meriting exclusion of the damages from the plaintiff's income. The Court reasoned that if the employer had paid the wages in the first place, they would have been taxed.

The result of the decision had the unfortunate effect of limiting the ability of some taxpayers, whose legal actions were not based in tort, to exclude their damages for physical injuries or sickness. For example, recipients of damages in no-fault cases where the cause of action was not based in tort law were unable to exclude the damages from income.

IRS's reasoning
The IRS justified removing a "tort test" by finding that case law following U.S. v. Burke and the 1996 amendment to Code Sec. 104(a)(2) had clarified the definition of excluded damages. This eliminated the need for the overly restrictive tort test. The final regulations provide guidance that there needs to be a direct link between the personal injury and the recovery.

The IRS's final regulations also reiterated that an exclusion under Code Sec. 104(a)(2) also applies to damages for emotional distress. It further explained that the exclusion applies, even if the damages are not necessarily attributable or related to a physical injury or physical sickness, to the extent that the damages for emotional distress are not in excess of amount paid for medical care related to such emotional distress.

Effective date
The final regulations apply to damages paid under a written binding agreement, court decree or mediation award entered into or issued after September 13, 1995, and received after January 23, 2012. The IRS advised that taxpayers may apply the final regulations to amounts paid under a written binding agreement, court decree, or mediation award entered into or issued after September 13, 1995, and received after August 20, 1996, and if otherwise eligible may file a claim for refund for a tax year for which the period of limitation on credit or refund under Code Sec. 6511 has not expired.

Please feel free to call this Doeren Mayhew for a more targeted explanation of how these regulations impact your circumstances.

If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.

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