Taxable Settlements « Settlement Law Blog

November 02, 2011

Are Damages Taxable for Wrongful Birth or Wrongful Life?

Are damages received for wrongful birth, or wrongful life, taxable? Those terms refer to cases in which a doctor’s failure to diagnose a problem in utero results in a birth that requires post-birth care and expense for the undiagnosed condition. Thus far, there are no authorizes providing the answer. Section 104(a)(2) of the Internal Revenue Code requires a physical personal injury for the income exclusion to operate. The IRS position will be that that no one injured the child. Rather, the child’s condition is the result of natural growth without intervention by others. The taxpayer’s position will be that the negligence is the physical injury, as in a car accident. We think the better position is that the damages are excludable from income.

November 16, 2010

At Last Some Clarity for Emotional Distress Damages

Emotional Distress, Section 104(a)(2) and Signs and Symptoms

The 1996 taxation of emotional distress. The inclusion in income of damages received on account of emotional distress has been clear since section 104(a)(2) was amended in 1996 to limit the exclusion to physical personal injuries. The legislative language taxing emotional distress damages is straightforward:

“For purposes of paragraph (2) [section 104(a)(2)], emotional distress shall not be treated as a physical injury or physical sickness.” Section 104(a) (flush language) of the Internal Revenue Code of 1986, as amended (“Code”).

The legislative history. That language was inserted in 1996 by P.L. 104-188, Small Business Job Protection Act of 1996, section 1605(b). The legislative history of that provision in the House Committee on Ways and Means Report introduces the concept that a “symptom” of emotional distress is included in the term emotional distress, and therefore taxes, as follows:

“The bill also provides that emotional distress is not considered a physical injury or physical sickness. ²⁴ Thus, 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.” H. R. Conf. Rep. No. 737, 104^th Cong., 2d Sess. (1996), 1996 C.B. 741, 1041 (1996)).

Note 24 to the above Report of the House Committee on Ways and Means provided the “symptom” limitation, as follows:

“The Committee intends that the term emotional distress includes physical symptoms (e.g., insomnia, headaches, stomach disorders) which may result from such emotional distress.” Id.

The practical reasons for change. The reason that nonphysical injuries were taxed beginning in 1996, and that emotional distress was also taxed, was, in part, that the Tax Court had a number of cases involving employees who had been laid off in the reductions-in-force of the 1980’s. Some of those employees were trying to exclude from income severance packages received as part of their separation from service. In leaving, those employees were asked to sign releases of all claims they might have for employment discrimination (age, gender, disability, race, etc.), whether or not they actually had such claims. Since those claims were personal-injury claims under prior law, employees were trying to exclude their severance pay on the ground that the employees had released those claims. See, e.g. Taggi v. United States, 35 F.3d 93 (2d Cir. 1994); Sodoma v. Comm’r, 71 T.C.M. (CCH) 3178 (1996), aff’d, 139 F.3d 899 (5^th Cir. 1998); Webb v. Comm’r, 71 T.C.M. (CCH) 2004 (1996).

There was also a dust-up in the Select Revenue Measures Subcommittee, then chaired by Congressman Pete Stark from Oakland, over a famous San Francisco cable-car passenger who clamed the 104(a)(2) exclusion for her $50,000 award, alleging that a cable-car accident had turned her into a nymphomaniac. The 29-year-old woman was crushed against a pole in the cable car. Psychiatric testimony was that the collision “unleashed emotions hidden deep in the dark closet of her mind.” She apparently took 100 lovers thereafter although that left her unsatisfied. A jury awarded her $50,000.00, instead of the $500,000.00 she sought. Rather than struggling with whether such a condition is physical or nonphysical, and against that background, Congress acted.

Symptoms and signs. Now, we learn, however, that the symptoms of emotional distress, which are all taxable, can be distinguished from “signs” of emotional distress, which still enjoy the exclusion from income. So what, you might ask, is a nontaxable sign of emotional distress, as distinguished from a taxable symptom of emotional distress?

Symptoms. The answer lies in medical literature, and, in fact, is very well settled there, although perhaps not among the political scientists on Capitol Hill. A symptom is apparently a perception by the patient and not observable by others. Insomnia is a symptom. The patient knows he or she is not sleeping. A visit to the doctor, however, cannot yield an observation of the insomnia. Similarly for headaches and stomach disorders. Insomnia, headaches and stomach disorders are observable by the patient but not by the doctor.[1]

Signs. A sign, on the other hand, is observable by the doctor, such as a heart attack, stress-induced diabetes, or stress-induced suicide. According to the Tax Court, damages on account of physical personal injures that are signs of emotional distress, rather than symptoms of emotional distress, are excludable from income. Parkinson v. Comm’r, T.C. Memo 2010-142, No. 7784-08 (June 28, 2010). Whether or not that rationale makes sense, the result is consistent with the legislative intent behind taxing emotional distress damages, i.e., to exclude from income only verifiable claims of physical injury, or, as the Service rules privately “observable bodily harm.” Priv. Let. Rul. 200041011 (July 17, 2000). This breakthrough reasoning to permit the exclusion of compensation for signs of emotional distress was achieved by the taxpayer pro se.

Although a breakthrough, the utility of the symptoms/signs rationale may be somewhat limited, based on the emotional-distress symptom cases decided to date. Below is a list of some of those and how they might be decided if the Parkinson rationale is correct. Not many that would be reversed.

Effect Of Symptom/Sign DistinctionOn Selected[2] Earlier Emotional-Distress Cases
Case	Symptoms	Signs	Holding	Parkinson effect
Domeny v. Comm’r, 99 T.C.M. (CCH) 1047 (2010)		Multiple Sclerosis Flare-up	Not Taxable	None
Save v. Comm’r, 98 T.C.M. (CCH) 57935 (2009)	Depression		Taxable	None
Lindsey v. Comm’r, TC Memo 2004-113, aff’d, 422 F.3d 684 (2005)	Fatigue, Insomnia, Indigestion, Hypertension[3]		Taxable	None
Wells v. Comm’r, 99 T.C.M. (CCH) 1032 (2010)	Depression		Taxable	None
Prinster v. Comm’r, Tax Ct. Summary LEXIS 99 (2009)	Headaches	Vomiting, Diarrhea, Hypertension, Hyperlipidemia, Diabetes	Taxable	Partial Reversal[4]
Moulton v. Comm’r, 97 T.C.M. (CCH) 1151 (2008)	Depression, Sleeplessness, Headaches		Taxable	None
Sanford v. Comm’r, 2008 Tax Ct. memo LEXIS 159 (2008)	Sleep Deprivation, Appetite Loss, Severe Headaches, Depression	Intensification of Asthma, Skin Irritation	Taxable	Partial Reversal
Goode v. Comm’r, 91 T.C.M. (CCH) 901 (2006)	Headaches, Stomachaches, Numbness		Taxable	None

[1] This, of course, is not entirely true since a doctor might observe fatigue or brain waves that are symptoms of the insomnia, or symptoms of the symptoms . . . unless they are signs by being observable through the symptoms. Nevertheless, we go with the flow of the Tax Court on this symptom/sign distinction because we know nothing about medicine. An ulcer could probably turn the taxable stomach-disorder symptom into a nontaxable sign since the ulcer is observable by the doctor.

[2] Selected cases are in this table because many cases are decided using the allocations in the settlement document, rather than the facts. There is generally no tension between the parties in determining the allocation between taxable and nontaxable elements. Even with punitive damages, there is no tension. Neither side wants them. They are taxable to plaintiffs. They may not be reimbursable from insurance for defendants. Defendants don’t want to be seen as paying punitives for bad behavior. Insurers are delayed n deducting them (they might correctly treat them as bulk or IBNR reserve additions for statutory purposes, but that treatment will not flow through to the tax return as a “loss incurred” under section 832(b)(5) under State Farm Mutual Automobile Ins. Co. v. Comm’r, 135 T.C. No. 26 (No. 5426-05, Nov. 8, 2010)).

[3] Hypertension might be a sign since it is observable by a physician. That the holding would have been reversed on that ground is a bit speculative. Many of the signs, including the sclerotic condition of Mr. Parkinson might well have origins in genetics, eating habits, exercise, etc. and were simply aggravated by the emotional distress.

[4] The Court noted that some of the signs may have been the result of diet and lifestyle. On that basis, the Parkinson conclusion could also be criticized.

July 06, 2010

Causing a heart attack as a physical injury

In Parkinson v Commissioner, T.C. Memo 2010-142 (June 28, 2010), the Tax Court excluded from income the compensation for a heart attack caused by the emotional distress of two co-employees of medical center. The Court distinguished a symptom of emotionaldistress, which is taxable, from objective signs of physical injury like a heart attack. The heart attacks are distinguishable from symptoms such as insomnia, headaches, stomach disorders that are mentioned in the legislative history of section 104(a)(2) as being mere symptoms of emotional distress that are taxable. The Court went much further than necessary on the distinction, however, by suggesting that phyiscal injuries resutling from emotinal distress are excludable under section 104(a)(2). That view seems vulnerable if an appeal is filed by the Service.

May 17, 2010

Taxable Settlements and Over-Structuring

The Risk Of Over-Structuring In Taxable Settlements.

The alternative minimum tax on fees, costs and interest paid by a plaintiff in taxable settlements creates a risk of structuring too much of the settlement. Plaintiffs in those situations may end up without sufficient money to pay tax. Thus, pro forma tax returns should be run on every taxable settlement involving a structured settlement.

Note that the alternative minimum tax does not apply to Civil Rights cases. It will apply in all other taxable cases, including interest and punitive damages recovered in nontaxable cases. Thus, care should be taken in every taxable case to compute the amount of tax to permit the plaintiff to make an informed decision about how to receive the settlement proceeds. In appropriate cases, that tax can be somewhat mitigated by structuring the attorneys fee.

An example: a client receiving a $1,000,000.00 settlement with fees and costs of $550,000.00 has only $101,000.00 left for immediate cash. Thus, there is probably no room for a structured settlement. The calculations are as follows:

Calculation of Net Available to Plaintiff
Settlement Amount	$1,000,000.00
Federal Regular Tax	($134,808.00)
Net Federal Alternative Minimum Tax	($141,692.00)
California Regular Tax	($49,008.00)
California Minimum Tax	($23,492.00)
Fees and Costs	($550,000.00)
Net to Plaintiff	$101,000.00

Notes about the federal taxes above: The plaintiff will pay the higher of the federal regular tax ($134,808.00) or the alternative minimum tax ($276,500.00). In the above illustration, the AMT exceeds the regular tax by $124,192.00. The federal miscellaneous itemized deduction for the attorney’s fees and costs of $550,000.00 gets reduced by 2% of adjusted gross income ($20,000.00) to $530,000.00. The AMT has a $45,000.00 exemption amount, which phases out to zero for this taxpayer.

Notes about the California taxes above. The plaintiff will pay the higher of the California regular tax ($44,233.00) or the state minimum tax ($72,500.00). In the above illustration, the minimum tax exceeds the regular tax by $28,267.00. The California miscellaneous itemized deduction gets reduced by 6% of adjusted gross income ($40,711.11) to $489,289.00.