by Bob Rywick

In a new publication (Publication 4345), the Internal Revenue Service explains the tax treatment of cash settlement awards. To help practitioners with clients who have received or are negotiating settlements, this article discusses the rules that apply to different types of awards. The type of settlement an individual receives is determined by his final settlement agreement.

Physical injuries or sickness
The amount of any damages received on account of personal physical injuries or physical sickness is excludable from income. This treatment applies whether recovery is by suit or agreement, and whether through a lump sum or periodic payments. Damages for personal injuries are amounts received (other than workers’ compensation) through prosecution of a legal suit or action based upon tort or tort-type rights, or through a settlement agreement entered into in lieu of such a prosecution.

If an action has its origin in a physical injury or physical sickness, all damages (other than punitive damages, see below) that flow from that injury or sickness are treated as payments received on account of physical injury or physical sickness, whether or not the recipient of the damages is the injured party. For example, damages received by an individual on account of a claim for loss of the company, affection and services of that individual’s spouse due to the physical injury or sickness of that spouse are excludable from gross income.

However, if an individual deducted medical expenses related to a physical injury, any damages received for physical injury are taxable to the extent that the amount deducted resulted in an individual tax benefit. The amount of the deduction must be reported as “Other Income” on Line 21 of Form 1040.

Observation: There would be a tax benefit only to the extent that the deduction resulted in some tax savings. Thus, with respect to medical expenses, only the amount actually deducted (i.e., the excess of the total medical expenses over 7.5 percent of adjusted gross income) would have to be included in gross income in the year the damages are received. Also, the amount includible in gross income couldn’t exceed the difference between the excess of the total itemized deductions over the individual taxpayer’s standard deduction for the year in which the medical expenses deduction was claimed.

Example 1: Your client, a single woman, suffered a physical injury in an automobile accident in 2001. She paid medical expenses of $15,000 that were related to her injury that she claimed as an itemized deduction on her 2001 federal income tax return. She had no other medical expenses for 2001. Her AGI for 2001 was $60,000 and the total of her itemized deductions for that year was $14,000, including $10,500 for her medical expenses ($15,000 less $4,500 (7.5 percent of AGI of $60,000)). The standard deduction for a single person in 2001 was $4,550.

In 2004, your client settled her lawsuit for the injuries she received in the accident for $200,000. Of this, she will have to include $9,450 in her gross income for 2004 (as “Other Income” on Line 21 of Form 1040) to reflect the benefit that she received in 2001 from deducting the amount of medical expenses she paid that were related to her injury.

This amount equals the lesser of the amount she deducted ($10,500) or the excess of her total itemized deductions ($14,000) over the amount of the allowable standard deduction for a single taxpayer in 2001 ($4,550), or $9,450.

Taxable amounts
Interest, punitive damages, damages for emotional distress or mental anguish, and for employment discrimination or injury to reputation generally are taxable and should be reported as follows:

1. Interest on any settlement is taxable and should be reported as interest income on Line 8a of Form 1040.
Example 2: The same facts apply as in Example 1, except that $30,000 of the $200,000 amount received in the settlement represents interest. Your client must report that $30,000 as interest income on Line 8a of Form 1040. As noted in Example 1, she must report $9,450 as “Other Income” on Line 21 of Form 1040. The balance of the settlement amount of $160,550 is nontaxable and does not have to be reported.

2. Punitive damages are taxable and should be reported as “Other Income” on Line 21. This is so even if the punitive damages are related to a physical injury or sickness.

3. Emotional distress or mental anguish payments are taxable to the extent that they exceed medical costs, not previously deducted, for treatment of emotional distress or mental anguish. A statement showing the entire settlement amount less related medical costs should be attached to the return. The net taxable amount should be reported as “Other Income” on Line 21 of Form 1040.

Observation: If part of a settlement from an employer is properly allocable to emotional distress, that part is not subject to employment taxes even though it is includible in gross income.

4. Employment discrimination or injury to reputation amounts are taxable and should be reported as “Other Income” on Line 21 of Form 1040.

5. Loss-of-use or loss-in-value of property settlements may be taxable if the settlement exceeds the taxpayer’s basis in the property. Property settlements that are less than the adjusted basis of the taxpayer’s property are not taxable and generally do not need to be reported.

However, the adjusted basis of the property has to be reduced to the extent of the amount received. If the property settlement exceeds the taxpayer’s adjusted basis in the property, the gain is treated as a gain on a capital asset. Gain on a personal capital asset is reported on Schedule D to Form 1040. Gain on a business capital asset is reported on Form 4797, Sale of Business Property.

Caution: Remember that the burden is on the taxpayer to establish its basis in the capital asset. If the taxpayer cannot establish the basis, the entire recovery will be taxable.

Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.

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