Small Business Taxes & Management

Special Report


IRS Issues Proposed Regulations on Exclusion of Physical Injury or Sickness Damage Awards

 

Small Business Taxes & ManagementTM--Copyright 2009, A/N Group, Inc.

 

Introduction

The IRS has issued proposed regulations (REG-127270-06) relating to the exclusion from gross income for amounts received on account of personal physical injuries or physical sickness. The proposed regulations reflect amendments under the Small Business Job Protection Act of 1996. The proposed regulations also delete the requirement that to qualify for exclusion from gross income, damages received from a legal suit, action, or settlement agreement must be based upon "tort or tort type rights." Emotional distress is not considered a physical injury or physical sickness and, thus, awards received solely on account of emotional distress are not excludable. However, damages for emotional distress, up to the amount paid for medical care, attributable to a physical injury or physical sickness are excluded from income. Note that these are proposed regulations. Some taxpayers may be able to file an amended return excluding income from such awards.

 

Background and Explanation of Provisions

The proposed regulations contain proposed amendments to the Income Tax Regulations to reflect amendments made to Section 104(a)(2) of the Internal Revenue Code by the Small Business Job Protection Act of 1996, Public Law 104-188, and to delete the "tort or tort type rights" test under Reg. Sec. 1.104-1(c).

Code Section 104(a)(2), as amended, excludes from gross income the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness. These proposed regulations conform the regulations to these statutory amendments and clarify the changes for taxpayers and practitioners.

 

The 1996 Act Amendments

The 1996 Act amended Section 104(a)(2) to provide expressly that punitive damages do not qualify for the income exclusion. The amendment was a response to divergent court opinions, some holding that punitive damages are received "on account of" a personal injury. The amendment is consistent with O'Gilvie, holding that punitive damages are not compensation for personal injuries and do not satisfy the "on account of" test under Section 104(a)(2).

The 1996 Act also amended Section 104(a)(2) to provide that the income exclusion generally is limited to amounts received on account of personal "physical" injuries or "physical" sickness. The 1996 Act further amended Section 104(a) to provide that, for purposes of Section 104(a)(2), even though emotional distress is not considered a physical injury or a physical sickness, damages not in excess of the amount paid for "medical care" (described in Section 213(d)(1)(A) or (B)) for emotional distress are excluded from income.

The proposed regulations reflect these statutory amendments. The proposed regulations also provide that a taxpayer may exclude damages received for emotional distress "attributable" to a physical injury or physical sickness.

 

The Tort Type Rights Test

The proposed regulations also eliminate the requirement that "personal injuries or sickness" be "based upon tort or tort type rights." That requirement in Sec. 1.104-1(c) was intended to ensure that only damages compensating for torts and similar personal injuries qualify for exclusion under section 104(a)(2). In United States v. Burke, the Supreme Court interpreted the tort type rights test as limiting the Section 104(a)(2) exclusion to damages for personal injuries for which the full range of tort-type remedies is available. The Court held that Section 104(a)(2) did not apply to an award of back pay under the pre-1991 version of Title VII of the 1964 Civil Rights Act because the damages awarded under the statute provided only a narrow remedy and thus did not compensate for a tort type injury. The Burke interpretation precluded Section 104(a)(2) treatment for similar personal injuries redressed by "no-fault" statutes that do not provide traditional tort-type remedies. Many critics thought the Burke remedies test was too restrictive.

Later legislative and judicial developments eliminated the need to base the Section 104(a)(2) exclusion on tort and remedies concepts. First, Commissioner v. Schleier, interpreted the statutory "on account of" test as excluding only damages directly linked to "personal" injuries or sickness. Second, the 1996 Act restricts the exclusion to damages for "personal physical" injuries or "physical sickness."

Accordingly, under the proposed regulations, damages for physical injuries may qualify for the Section 104(a)(2) exclusion even though the injury giving rise to the damages is not defined as a tort under state or common law. Nor does the Section 104(a)(2) exclusion depend on the scope of remedies available under state or common law. In effect, the regulations reverse the result in Burke by allowing the exclusion for damages awarded under no-fault statutes.

 

Proposed Effective/Applicability Date

These regulations are proposed to apply to damages paid pursuant to a written binding agreement, court decree, or mediation award entered into or issued after September 13, 1995, and received after the date these regulations are published as final regulations. However, taxpayers may apply these proposed regulations to amounts paid pursuant to a written binding agreement, court decree, or mediation award entered into or issued after September 13, 1995, and received after August 20, 1996. If applying the proposed regulations to damages received after August 20, 1996, results in an overpayment of tax, the taxpayer may file a claim for refund within the period of limitations under Section 6511.

Notwithstanding the date these regulations are proposed to become effective, the 1996 Act amendments to Section 104(a)(2), including the amendment restricting the exclusion to amounts received on account of personal physical injuries or physical sickness, are effective for amounts received after August 20, 1996, except for any amount received under a written binding agreement, court decree, or mediation award in effect on (or issued on or before) September 13, 1995. Since the 1996 Act amendments, courts have applied the statutory effective date in holding that amounts received on account of nonphysical injuries are not excludable. (Hennessey, T.C. Memo 2009-132; Green, T.C. Memo 2007-39. These regulations propose to conform existing regulations to amended Section 104(a)(2). To the extent that existing regulations conflict with amended Section 104(a)(2), the statute controls.

 

Text of Proposed Amendments to the Regulations

Par. 2. In Sec. 1.104-1, paragraph (c) is revised to read as follows:

Sec. 1.104-1 Compensation for injuries or sickness.

* * * * *

(c) Damages received on account of personal physical injuries or physical sickness -- (1) In general. Section 104(a)(2) excludes from gross income the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness. Emotional distress is not considered a physical injury or physical sickness. However, damages for emotional distress attributable to a physical injury or physical sickness are excluded from income under Section 104(a)(2). Section 104(a)(2) also excludes damages not in excess of the amount paid for medical care (described in Section 213(d)(1)(A) or (B)) for emotional distress. For purposes of this paragraph (c), the term damages means an amount received (other than workers' compensation) through prosecution of a legal suit or action, or through a settlement agreement entered into in lieu of prosecution.

(2) Cause of action and remedies. The section 104(a)(2) exclusion may apply to damages recovered for a physical personal injury or sickness under a statute, even if that statute does not provide for a broad range of remedies. The injury need not be defined as a tort under state or common law.

(3) Effective/applicability date. This paragraph (c) applies to damages paid pursuant to a written binding agreement, court decree, or mediation award entered into or issued after September 13, 1995, and received after the date these regulations are published as final regulations in the Federal Register. Taxpayers also may apply these proposed regulations to damages paid pursuant to a written binding agreement, court decree, or mediation award entered into or issued after September 13, 1995, and received after August 20, 1996. If applying these proposed regulations to damages received after August 20, 1996, results in an overpayment of tax, the taxpayer may file a claim for refund before the period of limitations under Section 6511 expires.

Notwithstanding the date these regulations are proposed to become effective, the statutory amendments to Section 104(a) under section 1605 of the Small Business Job Protection Act of 1996, Public Law 104-188, (110 Stat. 1838), are effective for amounts received after August 20, 1996, except for any amount received under a written binding agreement, court decree, or mediation award in effect on (or issued on or before) September 13, 1995.

 


Copyright 2009 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536


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--Last Update 09/15/09