Taxation of Judgments and Settlements

by Michael B. Bogdanow
Meehan, Boyle, Black & Bogdanow, P.C.
Boston, Massachusetts
© April, 2004

I. General Principles

Although many practitioners assume that judgments and settlements are not taxable, the issue is not quite that simple. Under section 61 of the Internal Revenue Code (” I.R.C.” or the ” Code” ), damages awarded as a result of a lawsuit are taxable unless specifically excluded by another section of the Code. In general, the issue is determined by focusing on how the Code would treat the money or other loss which the damages are intended to replace.1

Under section 104(a)(2) of the Code, damages received on account of personal physical injuries or physical sickness are excluded from gross income. This section provides the foundation for the view that most tort damages are not taxed. A 1996 amendment to the code changed the previous exclusion, which had applied to ” personal injuries or sickness,” and replaced it with the more restrictive provision ” personal physical injuries or physical sickness.” The amendment calls into question the applicability of a large body of pre-amendment case law permitting exclusions based on the broader ” personal injury” provision. The section 104(a)(2) exclusion applies whether recovery is realized through a court judgment or a settlement agreement,2 and even if the settlement was achieved without filing suit.3 Thus, voluntary settlements achieved or damages awarded as a result of claims based on personal physical injuries are generally excludable from gross income.4

In general, damages awarded for breach of contract,5 punitive damages6 and the interest portion of a judgment are taxable.7

II. Property Damage

Harm to property is taxable only to the extent the recovery exceeds the basis of the property.8 If the recovery is smaller than the basis of the property, and the property remains in the plaintiff’s possession, the basis is reduced by the amount of the recovery. If the recovery exceeds the income tax basis of the property, the plaintiff will realize a gain equal to the extent of that excess.9

III. Personal Injury and Emotional Distress Damages

The 1996 amendment to the tax code added the term ” physical” to the provision excluding from gross income damages received on account of ” personal physical injuries or physical sickness” .10 Prior to the 1996 amendment, section 104(a)(2) excluded from gross income all personal injury damages, such as past and future lost income,11 past and future medical expenses,12 pain and suffering,13 emotional distress,14 loss of consortium15 and injury to personal reputation.16

The 1996 amendment changing the exclusion from damages on account of ” personal injuries” to damages on account of ” personal physical injuries” restricts the types of settlements and awards that are excludable from income. Earlier cases that broadly interpreted ” personal injuries” to include non-physical injuries are now of questionable precedential value on this issue.

Prior to the 1996 amendment, in some cases, a plaintiff had been allowed to exclude from gross income an amount recovered on account of personal injuries suffered as a result of discrimination based on sex,17 age18 or race.19 However, these decisions have been called into question by the 1996 amendment and by decisions of the Supreme Court.20

In the pre-amendment case of Commissioner v. Schleier,21 the court held that a plaintiff seeking to exclude a damage award under 104(a)(2) must establish that her underlying cause of action giving rise to the recovery was ” based upon tort or tort type rights” and that the damages were received ” on account of personal injury.” Schleier involved a claim under the Age Discrimination in Employment Act of 1967 (” ADEA” ), and resulted in a settlement representing equal amounts for back pay and for liquidated damages under the ADEA. The Supreme Court concluded that none of the settlement amount could be excluded from income.

First, the court held that a recovery of back wages and liquidated damages under the ADEA is not ” on account of personal injuries or sickness” under 104(a)(2). Although age discrimination could cause personal injuries, the amount of back wages recoverable under the ADEA ” is completely independent of the existence or extent of any personal injury.” 22 The lost income may have been caused by the claimant’s turning a certain age or being discharged as a result of turning such age, but the court held that neither of these constituted a personal injury. The court also held that liquidated damages under the ADEA are not intended as compensation for personal injuries, but are punitive in nature, as they are based upon the employer’s knowledge of the unlawfulness of his conduct. Thus, they were not received on account of personal injuries.23

The court also concluded that recovery under the ADEA is not based upon ” tort or tort type rights,” because the ADEA only permits recovery of back wages and provides no compensation for any of the traditional harms, such as pain and suffering, emotional distress and harm to reputation, associated with personal injury.24 Thus, the claimant failed to establish either of the two essential requirements for exclusion: that the cause of action was based on tort or tort type rights,25 and that the damages were received on account of personal injury or sickness. Both requirements must be satisfied for exclusion from income and, therefore, the entire settlement amount was taxable. Thus, even before the enactment of the restrictive amendment in 1996, the Supreme Court had already begun to limit the types of awards that were excludable from income. By adding the requirement of ” physical” injury or sickness, the legislature continued this trend toward taxing settlements and judgments.26 Even when a physical injury impairs the ability of the plaintiff to work, which results in employment discrimination against him, if the cause of action is based on the discrimination rather than the injury, the resulting damages have been viewed as taxable.27

The code has also been amended to provide that damages based solely on emotional distress do not constitute damages on account of personal physical injuries for purposes of exclusion from gross income.28 A reasonable interpretation of the letter and intent of the legislation is that if the emotional distress is a direct result of a physical injury, the resulting damages, including those attributable to emotional distress, are still excludable from income. 29

IV. Punitive Damages

A 1996 amendment to the Code expressly provides that the exclusion from income for amounts received on account of personal physical injuries does not apply to punitive damages.30 The Supreme Court, construing the pre-amendment provisions of the Code, had already held that punitive damages were taxable.31 The amendment and the Supreme Court decision render punitive damages taxable in most cases.

O’Gilvie v. United States applied the pre-amendment Code provisions. The case involved the husband and two minor children of a woman who died of toxic shock syndrome, and who received a jury award of $1,525,000 actual damages and $10,000,000 punitive damages in a tort suit against the maker of the product that caused the decedent’s death. The litigation in the case concerned the petitioner’s legal entitlement to a refund on the income taxes paid on the $10,000,000 punitive damage award, and focused on the issue of whether section 104(a)(2) applies to (and thereby makes nontaxable) punitive damages received by a plaintiff in a tort suit for personal injuries.

The Supreme Court was influenced by several factors in determining that punitive damages could not be excluded under section 104(a)(2). First, the Court interpreted the statute’s language that allows for the exclusion from gross income of ” the amount of any damages received . . . on account of personal injuries or sickness” as imposing a stronger causal connection between the injury or sickness and the damages awarded than simple ” but for” causation. The Court interpreted the ” on account of” language within the exclusionary provision as applying only to those damages that were awarded by reason of, or because of, the personal injury, and not to punitive damages that do not compensate for an injury. The Court accepted the argument that punitive damages in such cases are not ” received . . . on account of” personal injuries, but rather are awarded ” on account of” a defendant’s reprehensible conduct and the jury’s need to punish and deter it. Moreover, the Court found this interpretation of the phrase ” on account of” as providing a meaning consistent with the dictionary definition.

The Court was also greatly influenced by its prior decision in Commissioner v. Schleier,32 where the Court held that section 104(a)(2) does not cover liquidated damages awarded under the Age Discrimination in Employment Act. The Court in Schleier concluded that such damages serve no compensatory function, but are instead punitive in nature, and therefore outside the exclusionary provision of section 104(a)(2). Applying the same reasoning in O’Gilvie, the Court concluded that punitive damages are not covered by section 104(a)(2) because they are an element of damages not designed to compensate victims, but are punitive in nature and directed at punishing a defendant’s conduct.

The Court also determined that the history of the statutory provision supported its holding, and could find no reasonable answer to the question of why Congress might have wanted the exclusion to cover punitive damages. The Court noted that punitive damages are not a substitute for any normally untaxed personal or financial quality, good, or asset, and that they do not compensate for any kind of loss. The Court also concluded that the statute’s language does not require, or strongly suggest, the exclusion of punitive damages from income.

V. Settlements

Section 104(a)(2) excludes from gross income all amounts received from settlement agreements reached through prosecutions of legal actions based on personal physical injuries or physical sickness, or through settlement agreements entered into in lieu of such prosecutions.33 If a settlement is intended to compensate for a personal physical injury or physical sickness, the amount of the settlement is excludable from gross income, except for amounts attributable to certain medical expense deductions taken in prior years.34 The nature of the claim and the purpose for which the parties entered a settlement agreement generally determine the extent of the recipient’s tax liability.35

If an agreement does not expressly state that the payment is made on account of personal physical injuries, some courts have taken the view that the payor’s intent in making the payment is the most important factor, while others have held that all relevant circumstances should be considered.36

If only one portion of the claim was for personal physical injury damages, and the plaintiff fails to establish an allocation of a settlement payment, the entire amount may be treated as taxable income, particularly if there is little support for the contention that a portion of the recovery was for personal physical injury.37 Furthermore, if an action has no basis in personal physical injury, the parties cannot convert an otherwise taxable settlement into a tax-free settlement by drafting the agreement in terms of compensation on account of personal physical injury.38 However, if one portion of the settlement should be excluded from income, the court can determine the allocation based upon the specific circumstances of the underlying claims, and by considering several factors, including the pleadings, evidence, settlement terms, and intent of the payor.39 Although the terms of the settlement agreement will be considered by the court, they are not dispositive of the issue of how to allocate the settlement amount between taxable and nontaxable claims.40 Allocations that are contrary to the actual circumstances of the settled claims do not need to be accorded any weight.41 Furthermore, a failure to include an express allocation in an agreement settling both tort and non-tort claims may cause most or all of the settlement amount to be viewed as taxable income.42

A portion of a personal injury settlement may be viewed as representing pre-judgment interest that is taxable. For example, a case may settle after judgment but prior to the resolution of an appeal. Even if the settlement agreement does not allocate any of the settlement to pre-judgment interest, the tax authorities or courts may view the settlement as including interest, particularly if the settlement is greater than the jury’s award of damages. Since interest is generally included as income, the amount which is viewed as attributable to interest is taxable.43

Since the taxability of settlements has undergone several statutory changes, and has been the subject of many judicial decisions, the practitioner should review any standardized settlement documents or forms and revise them to incorporate the most recent statutory changes. For example, as discussed above, the pre-1996 version of the tax code rendered settlements on account of personal injuries or sickness non-taxable; the 1996 amendment restricted this provision to amounts received on account of ” personal physical injuries or physical sickness.” 44

Therefore, to the extent that the practitioner is using forms or previously executed settlement agreements as models, the applicable language should be changed to reflect the current law.

VI. Structured Settlements

A structured settlement, which involves the payment of a settlement amount in regular installments (typically paid by a third party), offers advantages to both the plaintiff and the defendant. The primary advantage to the plaintiff is that, in general, if she does not have control over, and does not take actual or constructive delivery of the lump-sum amount, all payments (including any initial or final balloon payments) will be treated as non-taxable income even though generated largely through appreciation of the money over an extended period of time.45 Other benefits to the plaintiff include eliminating the cost and risk of investing a lump-sum payment, as well as shifting the risk of providing continued living expenses to the plaintiff should she live a longer life than expected. A defendant may benefit by being able to settle a claim through a smaller initial payment, and by shifting the long term obligation to a third-party payor.46 Disadvantages of a structured settlement include the risk of third-party insolvency and loss of control of the settlement amount once the structured agreement is in place. A professional experienced with structured settlements should be consulted to ensure that the settlement satisfies the applicable tax laws.

In Grieve v. General American Life Insurance Co., the court addressed an individual’s agreement not to sell, assign or transfer her right to structured settlement payments. As a result of her financial needs, she sought to transfer such rights in return for a relatively modest ” lump sum.” However, the court would ” not lend its approval to the voiding of unambiguous, bargained-for contract terms in order to enable” the would-be purchaser ” to profit, at an exorbitant rate of interest, from” the individual’s ” financial distress.” 47

VII. Contingent Fee Agreements

There is a split of authority as to whether the portion of a settlement used to pay a litigant’s contingent attorneys’ fees is taxable. The Fifth, Sixth and Eleventh Circuits have concluded that such amounts are excludable from gross income, while the Second, Third and Federal Circuits have held that such amounts are taxable.48

In Campbell v. Commissioner, the petitioner recovered a damages award for lost income in a discrimination case against her employer. The award was viewed entirely as gross income, although a portion of it was paid to the petitioner’s attorney pursuant to a contingent fee agreement. In some circumstances, such fees would be viewed as expenses incurred in generating income and would qualify as miscellaneous itemized deductions. However, the petitioner in this case was subject to the Alternative Minimum Tax, which precluded fees paid to attorneys from qualifying as deductible expenses. Therefore, the entire award, including the portion paid for attorneys’ fees, was subject to taxation.49

Two cases50 were granted certiorari by the United States Supreme Court on March 29, 2004. In each of these decisions, the circuit courts ruled that contingent fees, for which an attorneys lien would apply, are excludable from income. The Supreme Court’s decision may finally answer the contingent fee issue.51

VIII. Conclusion

The general view that settlements and judgments in tort cases are not taxable over-simplifies this often complex issue. Practitioners should remain current on the legal developments, and should either consult with professionals who regularly handle tax issues, and/or recommend that their clients consult with such professionals. To do otherwise could lead to liability for legal malpractice, as evidenced by the very close call of the attorney involved in Jalali v. Root.52 Although the judgment against attorney Root was reversed on appeal, the case is worth reading as a reminder of the importance of providing accurate advice, and referring your clients to the appropriate practitioner.53


1 Fono v. Commissioner, 79 T.C. 680 (1982), aff’d, 749 F.2d 37 (9th Cir. 1984); Raytheon Prod. Corp. v. Commissioner, 144 F.2d 110 (1st Cir.), cert. denied, 323 U.S. 779, 65 S. Ct. 192 (1944).

2 26 U.S.C. § 104(a)(2); United States v. Burke, 504 U.S. 229, 112 S. Ct. 1867, 1871 (1992).

3 See Paton v. Commissioner, T.C. Memo. 1992–627, 64 T.C.M. 1150 (1992) (exclusion from gross income applied where defendant settled as a result of implication in letter from plaintiff’s counsel that lawsuit would be filed).

4 26 U.S.C. § 104(a)(2); United States v. Burke, 504 U.S. 229, 112 S. Ct. 1867, 1873 (1992).

5 Raytheon Prod. Corp. v. Commissioner, 144 F.2d 110, 113 (1st Cir.), cert. denied, 323 U.S. 779, 65 S. Ct. 192 (1944); Church v. Commissioner, 80 T.C. 1104, 1108 (1983).

6 Rev. Rul. 84–108, 1984–2 C.B. 32; Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 432, 75 S. Ct. 473, 477 (1955); 26 U.S.C. § 104(a)(2); O’Gilvie v. United States, 519 U.S. 79, 117 S. Ct. 452, 136 L.Ed.2d 454 (1996).

7 Aames v. Commissioner, 94 T.C. 189 (1990); Rozpad v. Commissioner, 154 F.3d 1 (1st Cir. 1998); Kovacs v. Commissioner, 100 T.C. 124 (1993).

8 Raytheon Prod. Corp. v. Commissioner, 144 F.2d 110, 113 (1st Cir.), cert. denied, 323 U.S. 779, 65 S. Ct. 192 (1944).

9 Parker v. United States, 573 F.2d 42 (Ct. Cl.), cert. denied, 439 U.S. 1046, 99 S. Ct. 720 (1978).

10 26 U.S.C. § 104(a)(2).

11 See Norfolk & W. Ry. Co. v. Liepelt, 444 U.S. 490, 496, 100 S. Ct. 755, 759, reh’g denied, 445 U.S. 972, 100 S. Ct. 1667 (1980) (damages for lost future earnings are excludable from gross income); Rev. Rul. 85–97, 1985-2 C.B. 50 (compensation for lost past wages is excludable).

12 Seay v. Commissioner, 58 T.C. 32 (1972).

13 Seay v. Commissioner, 58 T.C. 32 (1972); Rev. Rul. 79-427, 1979-2 C.B. 120.

14 Fono v. Commissioner, 79 T.C. 680 (1982), aff’d, 749 F.2d 37 (9th Cir. 1984).

15 Rev. Rul. 68-649, 1968-2 C.B. 52.

16 Rev. Rul. 85-98, 1985-2 C.B. 51.

17 See Byrne v. Commissioner, 883 F.2d 211, 216 (3d Cir. 1989) (recovery in sex discrimination suit was received on account of personal injury and excludable from gross income). But see United States v. Burke, 504 U.S. 229, 112 S. Ct. 1867, 1874 (1992) (award for back wages in Title VII, sex discrimination action decided under statutory provisions prior to 1991 amendments to Title VII was includable in gross income).

18 See Rickel v. Commissioner, 900 F.2d 655, 661–64 (3d Cir. 1990) (recovery in age discrimination action excludable from gross income). But see Maleszewski v. United States, 827 F. Supp. 1553 (N.D. Fla. 1993) (acknowledging contrary authority, but concluding that damages awarded in age discrimination case are includable in gross income, because the claim is not tort-like and the damage award replaces amounts that would have been earned and taxed).

19 See Stocks v. Commissioner, 98 T.C. 1 (1992) (recovery for personal injury due to racial discrimination is excludable from gross income). But see Sparrow v. Commissioner, 949 F.2d 434, 441 (D.C. Cir. 1991), cert. denied, 112 S. Ct. 3009 (1992) (award of back pay in Title VII, race discrimination suit decided under statutory provisions prior to 1991 amendments to Title VII is includable in gross income).

20 Commissioner v. Schleier, 515 U.S. 323, 115 S. Ct. 2159, 132 L.Ed.2d 294 (1995); United States v. Burke, 504 U.S. 229, 112 S. Ct. 1867 (1992).

21 Commissioner v. Schleier, 515 U.S. 323, 115 S. Ct. 2159, 132 L.Ed.2d 294 (1995).

22 Commissioner v. Schleier, 515 U.S. 323, 330, 115 S. Ct. 2159, 132 L.Ed.2d 294, 303 (1995).

23 Commissioner v. Schleier, 515 U.S. 323, 331, 115 S. Ct. 2159, 132 L.Ed.2d 294, 303 (1995).

24 Commissioner v. Schleier, 515 U.S. 323, 334-36, 115 S. Ct. 2159, 132 L.Ed.2d 294, 305-06 (1995).

25 A large body of case law addresses the issue of whether a claim is ” tort or tort-like.” See Commissioner v. Schleier, 515 U.S. 323, 115 S. Ct. 2159, 132 L.Ed.2d 294 (1995).

26 Prasil v. Comm’r, T.C. Memo 2003-100, 2003 Tax Ct. Memo LEXIS 98 * 16-18 (2003) (settlement was entirely taxable where, other than ” petitioner’s self-serving testimony without corroborating evidence,” the record was ” devoid of any evidence that … sex discrimination caused a physical injury to or the physical sickness of” the petitioner).

27 Johnson v. United States, 76 Fed. Appx. 873, 874-877, 2003 U.S. App. LEXIS 18733 (10TH Cir. 2003) (since ” the actual cause of the loss of income and the ADA action was the unlawful termination, not the personal physical injury” the damages awarded for loss of salary were not exempt from gross income).

28 26 U.S.C. § 104(a)(5) provides that, for purposes of § 104(a)(2), ” emotional distress shall not be treated as a physical injury or physical sickness” (with a limited exception for the cost of some medical care attributable to emotional distress).

29 But see Johnson v. United States, 2002 U.S. Dist. Lexis 15894 (D. Colorado 2002) (” on account of physical injuries” requirement for exclusion from gross income for emotional distress damages was not satisfied where physical injury resulted in termination of employment, and termination of employment resulted in emotional distress).

30 26 U.S.C. § 104(a)(2).

31 O’Gilvie v. United States, 519 U.S. 79, 117 S. Ct. 452, 136 L.Ed.2d 454 (1996).

32 Commissioner v. Schleier, 515 U.S. 323, 115 S. Ct. 2159, 132 L.Ed.2d 294 (1995).

33 26 U.S.C. § 104(a)(2).

34 26 U.S.C. § 104(a)(2).

35 Burditt v. Commissioner, 77 T.C.M. (CCH) 1767, T.C.M. (RIA) 99,117 (1999); Metzger v. Commissioner, 88 T.C. 834 (1987), aff’d, 845 F.2d 1013 (3d Cir. 1988).

36 Pipitone v. United States, 17 F. Supp. 2d 793, 798 (N.D. Ill. 1998). See also Burditt v. Commissioner, 77 T.C.M. (CCH) 1767, T.C.M. (RIA) 99,117 (1999); Primozic v. Commissioner, 77 T.C.M. (CCH) 1604, T.C.M. (RIA) 99,095 (1999); Metzger v. Commissioner, 88 T.C. 834 (1987), aff’d, 845 F.2d 1013 (3d Cir. 1988).

37 See Villaume v. United States, 616 F. Supp. 185, 190 (D. Minn. 1985).

38 Hawkins v. Commissioner, 6 B.T.A. 1023 (1927).

39 See Lane v. United States, 902 F. Supp. 1439 (W.D. Okla. 1995).

40 Bagley v. Commissioner, 121 F.3d 393 (8th Cir. 1997).

41 Robinson v. Commissioner, 102 T.C. 116 (1994), aff’d in part and rev’d in part, 70 F.3d 34 (5th Cir. 1995); Elpi, Jr. v. United States, 968 F. Supp. 54 (D. Conn. 1997); Johnson-Waters v. Commissioner, T.C. Memo 1993-333, 66 T.C.M. 252 (1993).

42 Taggi v. United States, 835 F. Supp. 744, 746 (S.D.N.Y. 1993), aff’d, 35 F.3d 93 (2d Cir. 1994) (court allocated entire settlement amount to taxable income); Fitts v. Commissioner, T.C. Memo 1994-52, 67 T.C.M. 2136 (1994) (three-fourths of settlement amount viewed as taxable), aff’d without published opinion, 53 F.3d 335 (8th Cir. 1995).

43 Delaney v. Commissioner, 99 F.3d 20 (1st Cir. 1996).

44 26 U.S.C. § 104(a)(2).

45 Rev. Rul. 79-313, 1979-2 C.B. 75; Rev. Rul. 79-220, 1979-2 C.B. 74; Rev. Rul. 77-230, 1977-2 C.B. 214; Rev. Rul. 65-29, 1965-1 C.B. 59.

46 See 26 U.S.C. § 130.

47 Grieve v. General American Life Insurance Co., 58 F. Supp. 2d 319, 324 (D. Vt. 1999). Accord: J.G. Wentworth S.S.C. Limited Partnership v. Callahan, 2002 Wis. App. 183, 256 Wis. 2d 807, 649 N.W.2d 695 (2002) (anti-assignment clause in annuity settlement agreement is enforceable); First Providian, L.L.C. v. Evans, 852 So. 2d 908 (Fla. Dist. Ct. App. 2003) (right to receive structured settlement payments cannot be assigned by the recipient).

48 Campbell v. Commissioner, 274 F.3d 1312, 1314-1315 (10th Cir. 2001); Young v. Commissioner, 240 F.3d 369 (4th Cir. 2001); Srivastava v. Commissioner, 220 F.3d 353, 358 (5th Cir. 2000): Davis v. Commissioner, 210 F.3d 1346 (11th Cir. 2000); Raymond v. United States, 355 F.3d 107, 115 (2d Cir. 2004).

49 Campbell v. Commissioner, 274 F.3d 1312, 1314-1315 (10th Cir. 2001). Accord Kenseth v. Commissioner, 259 F.3d 881 (7th Cir. 2001); Raymond v. United States, 355 F.3d 107, 115 (2d Cir. 2004).

50 Banaitis v. Commissioner, 340 F.3d 1074, 2003 U.S. App. LEXIS 17913 (9th Cir. 2003); Banks v. Commissioner, 345 F.3d 373, 2003 U.S. App. LEXIS 19999 (6th Cir. 2003).

51 On a related but somewhat different issue – tax liability arising out of an attorneys’ fee award in an employment discrimination case under Title VII – the court in Porter v. United States Agency for International Development, 293 F. Supp. 2d 152, 157 (D.D.C. 2003) distinguished the contingent fee cases and ordered that the attorneys’ fees were to be paid separately from the underlying award, in an attempt to avoid the plaintiff’s incurring tax on the fees portion of the award. The judge ruled that ” the best course is to do what I can to ensure that the attorneys’ fee award never becomes a tax problem for Porter, by (i) making the fee award directly to counsel and not to Porter and (ii) explaining the nature of the award clearly, so that Porter or his tax adviser can refer to the explanation when preparing income tax returns, and so that the IRS can consider the explanation before attempting to impose a tax on Porter for the attorney’s fee award.”

52 Jalali v. Root, 109 Cal. App. 4th 1768, 1 Cal. Rptr. 3d 689, 692 (Cal. App. Ct. 2003) (reversing judgment against attorney arising out of his advice or failure to advise about tax consequence of award, because the status of the law was uncertain).

53 For a more detailed discussion of the taxability of settlements and judgments, see Chapter Seventeen of Michael Bogdanow, Massachusetts Tort Damages, Second Ed. (Lexis Law Publishing).