tax treatment of judicial recovery


Private & Confidential
Dr. Tooth
123 Main Street 
Small Town, USA 10001

              Re:              U.S. Federal Income Tax Treatment of Judicial Recovery

Dear Dr. Tooth,

You have requested our advice regarding the U.S. federal income tax treatment of a judicial recovery you have received.  Our analysis regarding the proper tax treatment is discussed below along with our conclusions regarding the proper tax treatment.  Our conclusions are based on facts represented by you, but not verified by us.  If any of the facts in our letter are inaccurate or incomplete, please let us know so that we can revise our conclusions if necessary.

This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding tax penalties that may be imposed on the taxpayer.

Facts

You are a dentist in Small Town, USA.  Since graduating from dental school in 2001, you have built a successful dental practice.  Last year a billing dispute arose between you and Mr. Smith, a former patient of yours who is generally well-respected in Small Town, USA.  As a result of this billing dispute, Mr. Smith spread a false rumor that you were a carrier of a serious infectious disease.  Most of your patients decided to change dentists as a result of this rumor.  You suffered significant financial, emotional, and physical consequences of these events.  You sued Mr. Smith for defamation and intentional infliction of emotional distress.  You were awarded a jury verdict, and recovered $3.6 million on damages from Mr. Smith.

The $3.6 million damages award you received was allocated by the court among the following categories:

1.    $1,000,000 in lost past and future wages;
2.    $50,000 in reimbursement for past medical expenses;
3.    $20,000 in reimbursement for future medical expenses;
4.    $30,000 in reimbursement for attorney’s fees;
5.    $2,000,000 in punitive damages;
6.    $300,000 for pain and suffering; and
7.    $200,000 for emotional distress.

Additionally, you incurred $50,000 of attorney’s fees in relation to this legal action.

Issue


What is the U.S. federal income tax treatment of the $3.6 million award you received?

Conclusion


The $3.6 million award you received will be subject to the following U.S. federal income tax treatment:

1.    $1,000,000 in lost past and future wages will be taxed as
2.    $50,000 in reimbursement for past medical expenses will be taxed as
3.    $20,000 in reimbursement for future medical expenses will be taxed as
4.    $30,000 in reimbursement for attorney’s fees will be taxed as
5.    $2,000,000 in punitive damages will be taxed as
6.    $300,000 for pain and suffering will be taxed as
7.    $200,000 for emotional distress will be taxed as

Analysis


The Internal Revenue Code (the “Code”)[1] specifies the U.S. federal income treatment applicable to various categories of money judgments received as a result of a lawsuit.  Amounts received for most categories of damages are governed by §§ 104-106.

In general, § 104(a)(2) provides that damages received for personal physical injury or physical sickness are excluded from a taxpayer's gross income.  Additionally, compensatory damages received for emotional distress or mental or emotional injury that is attributable to a physical injury or physical sickness are excluded from a taxpayer's gross income.  Other damages are generally not excludable from a taxpayer's gross income.[2]

The analysis of tax treatment for the categories applicable to your judgment is discussed below.

1.    Lost Past and Future Wages

Section 61 provides that gross income "means all income from whatever sources derived".  Therefore, unless an exception exists in the Code excluding an item of income from gross income, the item is includable in gross income.  Amounts received as damages to compensate a taxpayer for lost past and future wages are intended to replace earnings which are taxable income to the taxpayer.  No exclusion from gross income exists in the tax code for damages received as compensation for lost past and future wages.  Therefore, damages you recovered attributable to lost past and future wages should be included in gross income.

2.    Past Medical Expenses

Amounts received as damages for medical expenses attributable to physical injuries or sickness are excludable from gross income.[3]  Amounts received as damages for medical expenses attributable to emotional distress are not excludable from gross income except to the extent such damages relate to payments for medical expenses related to emotional distress.[4]  The past medical expenses you incurred related to emotional distress.  Therefore, the damages you recovered attributable to medical expenses you have actually incurred should be excluded from gross income.  Damages you recovered attributable to medical expenses in excess of those expenses actually incurred by you should not be excluded from gross income.

3.    Future Medical Expenses

The damages you received relate to anticipated but not yet incurred medical expenses related to emotional distress.  Under the same analysis as above, the damages received are not excludable from gross income as they are not expenses you have yet incurred.  However, medical expenses you incur in the future should be deductible from gross income, subject to certain limitations.[5]

4.    Attorney’s Fees

The issue of whether recovery for attorney's fees is excludable from gross income has not been clearly decided.  The U.S. Supreme Court has ruled that recovery for contingent attorney's fees is includible in gross income.[6]  However, the American Jobs Creation Act of 2004 permits the deduction of attorney's fees recovered for unlawful discrimination and certain other federal "whistleblower" claims.[7]  Your recovery for attorney's fees related to defamation and emotional distress are not of the same type or nature as an unlawful discrimination or federal "whistleblower" claim, where there is a federal public policy to encourage such cases by providing for the deductibility of attorney's fees.  Therefore, you should include the amount you recovered attributable to attorney's fees in your gross income.

Legal expenses incurred in connection with running a business or preserving an existing business reputation and goodwill are deductible as ordinary business expenses.[8]  Therefore, the $50,000 of attorney's fees you paid to your attorney can be deducted as an ordinary and necessary business expense.

5.    Punitive Damages

Punitive damages are includible in gross income unless they are received in certain civil actions for wrongful death.[9]  The punitive damages you recovered were a result of defamation and intentional infliction of emotional distress.  These categories of punitive damages are not excluded from gross income.  Therefore, the amount you recovered attributable to punitive damages should be included in gross income.

6.    Pain and Suffering

Damages for pain and suffering resulting from nonphysical personal injuries, including defamation, are not excludable from gross income for U.S. federal income tax purposes.[10]  The pain and suffering you incurred was a result of the defamation against you, and was not a result of physical personal injuries you experienced.  Therefore, the amount you recovered attributable to pain and suffering should be included in gross income.

7.    Emotional Distress

Damages for emotional distress incurred on account of nonphysical personal injuries, including defamation, are not excludable from gross income for U.S. federal income tax purposes.[11]  Emotional distress is not considered by the IRS to be a physical injury in itself, despite the possible presence of physical symptoms.  Therefore, recoveries arising out of emotional distress are not excluded from gross income except to the extent that the damages are recovered for amounts paid for medical care attributable to the emotional distress.[12]  Your recovery for emotional distress was not attributable to the medical expenses you incurred, as those expenses were recovered separately, as discussed above.  Therefore, the amount you recovered attributable to emotional distress should be included in gross income.

Please feel free to call me at (408) 555-1212 if you would like to discuss this further.

Best Regards,


Travis A. Wise
              3

[1] Unless we state otherwise, all section or “§” references are to the Internal Revenue Code of 1986, as amended, and the Treasury Regulations promulgated thereunder.
[2] See § 61(a).
[3] See § 104(a)(2).
[4] Id.
[5] See § 213(a).
[6] See C.I.R. v. Banks, 543 U.S. 426, 2005.
[7] See § 62(a)(20).
[8] See § 162(a).
[9] See §§ 104(a) and 104(c).
[10] See § 104(a).
[11] See § 104(a).
[12] See § 104(a).  See also Rev. Rul. 96-65, 1996-2 C.B. 6, where “medical care” for purposes of this rule is defined in § 213(d)(1)(A) and (B).

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