Taxation of Personal Sickness/Injury and/or Disability Lawsuit Settlement Awards
If you should initiate a lawsuit due to personal sickness or injury and/or based upon a disability claim and receive a legal settlement award, you will likely have questions about whether the proceeds must be reported as income on your tax return. Whether you must include the proceeds in income depends on all the facts and circumstances of your case. The settlement agreement in your case may have multiple elements that the parties to the lawsuit have allocated. For example, the agreement may include allocations of the award to back pay, emotional distress, attorney fees and other claims. In general, the IRS will not disturb an allocation if it’s consistent with the substance of the settled claims.
To determine the appropriate tax treatment of a recovery from either the recipient’s or payor’s perspective, one must examine the origin of the claim. The origin and nature of the claim can likely be ascertained by examining the following: a) the Complaint; and b) Settlement Agreement. The Complaint is the most persuasive evidence of how payments received pursuant to a judgment or a settlement should be characterized. Rev. Rul. 85-98. Settlement proceeds may be excludable from income under: A) Code Sec. 104(a)(2), or in the alternative B) IRC section 105(c), or C) if a disability award based on employment disability insurance and the employee pays insurance premiums or the Employer pays under certain circumstances.
A. IRC Section 104(2) excludes from gross income “the amount of any damages (other than punitive damages) received on account of personal physical injuries or physical sickness.” For purposes of section 104, damages mean an amount received (other than workers’ compensation). IRC Section 104(a)(3) states that except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 for any prior taxable year, gross income does not include amounts received through accident or health insurance (or through an arrangement having the effect of accident or health insurance) for personal injuries or sickness. IRS Publication 4345, Settlements Taxability states that “[i]f you receive a settlement for personal physical injuries or physical sickness and did not take an itemized deduction for medical expenses related to the injury or sickness in prior years, the full amount is non-taxable. Do not include the settlement proceeds in your income.”
The exclusion provided under IRC Section 104(a)(3) does not apply to amounts received through accident or health insurance amounts received by employees in specific circumstances. Internal Regulation Section 1.104-1(d) refers to Section 1.105-1 for rules relating to when the exclusion does/does not apply, and the accident or health plan is attributable to employer contributions.
B. Under Code Section 105(a), amounts received by an employee through accident or health insurance for personal injuries or sickness must be included in gross income to the extent those amounts:
1) Are attributable to contributions by the employer that were not includible in the gross income of the employee; or
2) Are paid by the employer.
Payments that are includible in income under Code Sec. 105(a) may nevertheless be excludable from income under Code Sec. 105(c) if they meet one of two requirements:
1) The payments are for the permanent loss of a member or function of the body, or the permanent disfigurement of the taxpayer, a spouse or dependent; and
2) The payments are computed with reference to the nature of the injury and without regard to the period the employee is absent from work.
In order to be excludible under IRC section 105c(1) the insurance payment must fall into one of three categories: 1) payments for the permanent loss or loss of use of a member of the body; 2) payments for the permanent loss or loss of use of a function of the body; or 3) payments for permanent disfigurement.
C. In addition, even if the exclusions under IRC sections 104 and 105 discussed above do not apply, disability benefits are tax-free to the extent the employee paid premiums with post-tax income. See IRC sections 104 & 105 and Regulations thereunder. Premiums paid by employees using payroll deductions after taxes and withholdings have been taken or the employer funds and reports the premiums as taxable wages on the employees’ W-2s (grossing-up the employees’ income). In such a case, income taxes are paid on the premium dollars so benefits paid to employees will be tax-free. Some plans provide for a combination of funding with pre-tax and post-tax dollars. In which case, some of the premiums are taxable and some are tax-free; likewise, some of the benefits would be taxable and some tax-free. See Reg. Section 1.105-1c (1).
Employers have the flexibility to apply several different funding approaches across all employees or select different funding models for different classes of employees. Whether the benefits are taxable depends upon who paid for the initial insurance premiums and whether they were paid with pre-tax or after-tax dollars and who paid the premiums (employee or employer). If the employee pays the premiums, then disability proceeds are not taxable. If the taxpayer pays the premiums, but they are included as taxable income on his return, then the benefits are not taxable.
One thing is clear, the question of whether settlement payments are taxable is complicated. If you receive a Form 1099 with taxable proceeds listed on it, the IRS will expect the income to be reported. If you should receive a legal settlement contact an attorney or CPA for tax advice.
Bowman Law Firm
Gene M. Bowman, Attorney and Retired CPA
