Category: Individuals
Subject: Lawsuit Settlement
Title: Taxability of Personal Injury Awards
IRC Sections: 104(a)(2)
Filename: 1390.html
Date Produced: 04/98

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Background
Taxpayer filed a lawsuit in 1992 for defamation of character and slander, incurring general and special damages. After a jury trial, the taxpayer obtained a judgment in 1996. In July, 1997, the judgment was compromised and the taxpayer received a settlement.

Issue
What is the taxability of the settlement amount?

Answer
The settlement is fully taxable.

Discussion
Internal Revenue Code (IRC) Section 104(a)(2) provides an exclusion from income for damages received due to personal injury or sickness. There was for many years a controversy in the courts concerning the excludability of damages for nonphysical injuries, including defamation. In addition, there was a controversy concerning the excludability of punitive damages.

Section 1605(a) of The Small Business Job Protection Act of 1996 (P.L. 104-188) ended these controversies by explicitly providing that only damages for physical personal injury and physical sickness are excludable from income. In addition, this law change also explicitly removes punitive damages from excludability.

The changes are generally effective for damage amounts received after June 30, 1996. However, there is a grandfather exception for amounts received after the general effective date pursuant to a written binding agreement, court decree, or mediation award in effect (or issued on or before) September 13, 1995.

Here is the text of Section 104(a)(2) before the law change.

Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include--

(a)(2) the amount of any damages received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injuries or sickness;

Here is the text of Section 104(a)(2) after the law change.

Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include--

(a)(2) 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 of personal physical injuries or physical sickness; [Emphasis supplied.]

Attached are the following references.

1. IRC Section 104(a) as currently in effect.
2. Partial amendment history of Section 104(a).
3. Committee Reports under P.L. 104-188 regarding Act Section 1605(a).
4. Excerpt from the General Explanation of Tax Legislation Enacted in the 104th Congress, Prepared by the Staff of the Joint Committee on Taxation (a.k.a., the Blue Book).

Since the law change in question is fairly recent, there are no interpretive court decisions. There is only one published IRS ruling on new Section 104(a)(2). Revenue Ruling 96-65, 1996-2 CB 6, holds that damages for emotional distress stemming from race discrimination under Title VII of the 1964 Civil Rights Act are not excludable from income. I see no private rulings based on the amended statute.