Recent Cases on the Tax Treatment of Settlements
A federal district court, a circuit court of appeals and the IRS have recently ruled on cases relating to the tax treatment of various types of settlements. Although the cases vary widely--a car accident, false imprisonment and patent infringement--they help clarify certain tax results in the uncertain area of settlements. Internal Revenue Code Section 104(a)(2) generally provides that nonpunitive damages received by an individual as compensation for personal physical injury or personal physical sickness are excluded from income. Recent legislation sought to clarify certain nuances under the provision relating to punitive damages and physical conditions stemming from emotional distress.
Stadnyk v. Commissioner
This case relates to settlement payments received for false imprisonment. A bank erroneously stamped a check--that had a stop payment order placed on it--as “NSF” for insufficient funds. Following the check’s return to the merchant, a criminal complaint was filed against the individual resulting in her arrest, processing and detention. The individual sued the merchant and the bank for the alleged psychological damage sustained as a result of the episode, and she received damages in settlement of the case. The Tax Court found that the plaintiff’s stated basis for recovery related to nonphysical personal injuries, including emotional distress and mental anguish, which are not excludable from gross income under IRC Section 104(a)(2). The Sixth Circuit Court of Appeals agreed with the Tax Court, finding that the settlement agreement included no indication that settlement amounts were paid on account of any physical injury (Stadnyk v. Comm’r., 105 AFTR 2010-537 (CA-6, 2/26/2010)).
Chappell v. International Steel Group
A federal district court found that an individual’s settlement amount resulting from a motor vehicle accident was excludable from gross income under IRC Sec. 104(a)(2). As a result, there was no need for the payer of the settlement amount to report information relating to the settlement to the IRS. The plaintiff in this action filed a negligence suit for recovery of damages relating to back injuries sustained as a result of a motor vehicle accident with an employee of the defendant. Chappell sought recovery for medical expenses incurred, lost wages, pain and suffering and compensation for future medical bills and pain and suffering. A settlement was reached. The defendant sought to require the plaintiff to complete a Form W-9 for tax reporting purposes. The court ruled that the plaintiff’s recovery was excludable under IRC Sec. 104(a)(2) and, as a result, there was no reason for the defendant to require the plaintiff to report the settlement amount. The court noted that the plaintiff’s cause of action was properly one based on a tort-type theory and that the damages were received on account of personal injuries or sickness (Chappell v. International Steel Group, 102 AFTR 2d, 2010-563 (DC-IN, 2/26/2010)).
Chief Counsel Advice 201008035
This matter relates to income received under a patent infringement settlement agreement. The IRS concluded that an accrual method taxpayer may use the deferral accounting method set forth in Revenue Procedure 2004-34, 2004-1 CB 991, for advance payments received under an agreement entered into in a prior year. In so finding, the IRS determined that the accounting-method change is justifiable so long as the method for determining the portion of the payment allocable to such payment is based on objective criteria.
If you would like to discuss the tax treatment of settlements you are working on, please
contact us.
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Since technical information is presented in generalized fashion, no
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For additional information on the issues discussed, please contact
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Tom
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for the purpose of avoiding tax penalties that may be imposed on the
taxpayer.
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