Those who receive damages from physical injuries or sickness are not required to pay tax on the damage award or settlement. That is the general rule. But what about ancillary claims by others?
What about a lawsuit for physical damage that also includes a claim for the injured parties spouse? What if the taxpayer-husband was injured and the taxpayer-wife included a claim in the lawsuit for loss of consortium? Would the taxpayer-wife have to pay income tax on the award for loss of consortium? The IRS addresses this in PLR 202050009. The answer may not be what you think it is.
Facts & Procedural History
The taxpayer-husband was riding his bike and was hit by a car. The taxpayer-husband suffered severe and permanent physical injuries.
The taxpayers sued the company that employed the driver. The suit was for negligence of the employee. It sought recovery for “damages foreconomic injuries (medical bills), for noneconomic injuries of mental anguish, loss of enjoyment of life, disability, pain, suffering, and other injuries and damages (collectively, “pain and suffering”), as well as damages for loss of consortium.”
The jury awarded damages for past and future economic damages, past and future noneconomic damages (pain and suffering), damages for past and future loss of consortium.
The taxpayers submitted a ruling request to ask whether the amounts were subject to income tax. These rulings can help avoid audit by the IRS (as you attach the ruling to your tax return, usually) and penalties.
Exclusion for Personal Injuries or Sickness
Section 104 excludes amounts for damages that are received on account of physical injury or sickness. This includes amounts received in a lawsuit or settlement based on tort-type rights. This includes most personal injury claims.
While the recovery requirement is broad, the personal injury or sickness requirement is narrow. It excludes damages attributable to emotional distress attributable to a physical injury or sickness. This emotional distress rule can limit the amount of damages that are tax free. This usually raises questions where damages are received for sickness, not necessarily physical injuries. The damages from a sickness may only be for the emotional distress that resulted.
Whether damages are taxable or not is frequently litigated in tax court and in other courts.
If you review the court cases, you will find hundreds of these cases. We have covered several of them on this website (here is an example).
There are more cases involving emotional distress than those involving an actual physical injury and damages for the injury. But even within these direct physical injury cases, there are novel and unique fact patterns (here is an example involving a taxpayer born with a medical condition).
The volume of sickness and emotional distress cases and the nuances for the physical injury cases can be misleading. It can cause some to believe that damages received in direct physical injury cases are taxable when they are not.
The facts in the present ruling provide an example of this. The taxpayer-wife received an award for loss of consortium. She was not physically injured.
Damages for Loss of Consortium
In this case, the taxpayer-husband clearly suffered a physical injury. The jury’s award for past and future economic damages and past and future noneconomic damages (pain and suffering) stem from the physical injuries. There is little doubt these amounts are excluded from income under Section 104.
But what about the award to the taxpayer-wife for loss of consortium? Loss of consortium generally refers to the deprivation of the benefits of a family relationship due to injuries caused by a wrongdoer. Are the damages the taxpayer-wife received for loss of consortium excluded from income under Section 104?
The IRS ruling cites the legislative history for Section 104, which states:
… If an action has its origin in a physical injury or physical sickness, then all damages (other than punitive damages) that flow therefrom are treated as damages received on account of personal physical injuries or physical sickness whether or not the recipient of the damages is the injured party. For example, damages (other than punitive damages) received by an individual on account of a claim of loss of consortium due to the physical injury or physical sickness of such individual’s spouse are excludable from gross income.
Based on this, the IRS concludes that the award to the taxpayer-wife was excluded from tax.
Those who receive damages for physical injuries or sickness are not required to pay tax on the damages they receive for the physical injury or sickness. If the damages are for physical injury for a tort or personal injury claim, this includes damage awards received by the spouse who was not physically injured.