Category: Individuals
Subject: Lawsuit Settlement or Judgment
Title: Taxation of Malpractice Judgment
IRC Sections: 104(a)(2)
Filename: 1194.html
Date Produced: 01/95

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Facts
Individual taxpayer (TP) was awarded a $1.5 million judgment against her attorney for negligent representation in a divorce action. According to the complaint, the attorney agreed to represent TP skillfully, reasonably, and diligently in the divorce action. The jury found that the attorney failed to do as he agreed, and as a result, TP suffered economic injury by way of having accepted a lower financial settlement (i.e., property settlement and alimony arrangements) than TP would otherwise have been entitled.

Issues
You have stated that you believe the settlement is excluded from TP's income under Internal Revenue Code (IRC) Section 104(a)(2), and you have asked for my thoughts on your conclusion.

Answer
I have extremely strong reservations about the conclusion set forth above.

Discussion
IRC §104(a)(2) provides that gross income shall not include the amount of damages received...on account of personal injury or sickness.

Regulation §1.104-1(c) provides in part that the term "damages received.." means an amount received...through prosecution of a legal suit or action based on tort or tort type rights. [Emphasis added.]

Black's Law dictionary defines the term tort as follows.

A private or civil wrong or injury, including action for bad faith breach of contract, for which the court will provide a remedy in the form of an action for damages. A violation of a duty imposed by general law or otherwise upon all persons occupying the relation to each other which is involved in a given transaction. There must be a violation of some duty owing to the plaintiff, and generally such duty must arise by operation of law and not by mere agreement of the parties.

A legal wrong committed upon the person or property independent of contract. It may either be (1) a direct invasion of some legal right of the individual; (2) a direct infraction of some public duty by which special damage accrues to the individual; (3) the violation of some private obligation by which like damage accrues to the individual.

Common examples of tort or tort-like injuries typically afforded exclusion under Section 104(a)(2) are 1) age, sex, and racial discrimination; 2) slander, libel, and defamation of character; 3) actual physical injuries; and 4) mental pain and suffering.

There are numerous §104(a)(2) cases which turn on the issue of whether the damages are the result of breach of contract. If so, the damages are typically held to be non-excludible under §104(a)(2).

My reading of the complaint in this matter leads me to believe that TP's damages flow from the lawyer's breach of his contractual arrangement with her as opposed to his violation of some statutorily established right. Based on my understanding of the term, this would not be a tort. If my understanding is correct, then the judgment would not be excludible under §104(a)(2).

I am not an attorney; accordingly I am not qualified and I am not opining upon whether the judgment in question is the result of a tort or tort-like injury under local law. This issue must be handled by a competent attorney in the jurisdiction in question, presumably Connecticut. Ultimately, the conclusion to the §104(a)(2) question boils down to whether TP's injury is a tort under local law. Only a competent attorney can help us with that question.

I suggest that you share my findings with the attorney who represented TP and get his or her opinion as to whether TP's claim represents a tort under local law. I would be happy to participate in a conference call if you wish.

If §104(a)(2) does not apply, it may be possible to exclude at least a portion of the judgment under other theories. We should discuss this possibility in the event §104(a)(2) is found to be inapplicable.