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U.S. INCOME TAX OF PERSONAL INJURY AWARDS AND SETTLEMENTS

For eighty years federal law did not impose income tax on damages or settlements “on account of” personal injuries. The applicable rationale is that a person’s ability to generate income is somewhat destroyed by injury to one’s body. Personal injury recoveries are therefore considered to be in the nature of a return of “human capital.” The logic that restoration of capital is not income came from the courts. It was promptly codified by Congress in 1918.

In 1996, Congress again reacted to the logic of the courts by clarifying the taxable nature of recoveries from personal injury litigation and by tightening up the rules. Receipts that do anything other than make the victim whole by returning personal or financial capital are now taxable. Section 104(a) of the Internal Revenue Code was also amended to add these additional words to make it rather clear that “emotional distress shall not be treated as a physical injury or physical sickness.” Likewise, the statute also made it clear than punitive damages were to be taxed.

In a surprising decision in 2006, the U.S. Court of Appeals for the D.C. Circuit has ruled that the federal government may not tax damage awards for emotional distress unrelated to lost wages or earnings.

A three-judge panel ruled Aug. 22 that the federal law allowing the taxing of such awards was unconstitutional because such awards are not income within the meaning of the 16th Amendment giving the federal government the right to tax income. Murphy v. United States, No. 05-5139.

To see how your award or settlement may be taxed complete and send the form.

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