Serious Injury Settlements–Are They Taxable?

Many people we have represented in serious personal injury cases whether they workplace accidents, trucking accidents, automobile accidents or dangerous products have asked whether settlement proceeds or payments made to an injured party as aresult of a jury verdict are taxable. The general rule is that those payments are not taxable.
The Internal Revenue Code provides, “Except as otherwise provided”, gross income for the purpose of calculating Federal income tax includes “all income from whatever source derived”. Sec. 61(a). This definition is sweeping in scope, and exclusions from income are to be narrowly construed. However, Section 104 provides for an exclusion from gross income for certain payments received as compensation for injuries or sickness. Specifically, section 104(a)2 provides in part:
SEC. 104. COMPENSATION FOR INJURIES OR SICKNESS.
(a) In General. — 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 —
* * * * * * *
(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;
The regulations under section 104 provide that the term “damages received (whether by suit or agreement)” means “an amount received (other than workmen’s 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 prosecution.” Sec. 1.104-1(c), Income Tax Regs. In the case of Commissioner v. Schleier, 515 U.S. 323, 328 (1995)., the U.S. Supreme Court established a two-prong test for determining whether a taxpayer is eligible to exclude income under section 104(a)(2). The taxpayer must demonstrate (1) that the underlying cause of action giving rise to recovery is based upon tort or tort-type rights, and (2) that the damages were received on account of personal injuries or sickness. Id. at 336-337.
A word of caution is in order. Although payment made in satisfaction of a judgment for compensatory damages in personal injury cases is not taxable, any payment made in satisfaction of a verdict or judgment for punitive damages is now taxable