If you’ve received damages from physical injuries or sickness, you don’t have to pay tax on the settlement or award. But what if others are also making ancillary claims in the same lawsuit? The case of the taxpayer-husband being injured and the taxpayer-wife making a claim for loss of consortium raises questions about the tax liability of the award. Does the taxpayer-wife have to pay income tax on the award for loss of consortium? The IRS provides an answer to this question in PLR 2020050009, and the answer may surprise you.
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 for economic 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), and 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 audits 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 about where damages are received for sickness, not necessarily physical injuries. The damages from 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). There are even cases involving the attorney fee portion of lawsuit awards and ways the attorney can minimize their own tax.
The volume of sickness and emotional distress cases and the nuances of 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 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.
Damages received for physical injury or sickness are considered tax-free. This means that individuals who receive compensation for such damages do not have to pay taxes on the amount they receive. This applies to both the person who sustained the physical injury and their spouse if the damages are awarded for a tort or personal injury claim. This is a significant benefit for those who have suffered physical harm and provides some level of financial relief as they recover from their injury or illness. As this case shows, the IRS does not agree that loss of consortium qualifies. Those taking this position may want to consider this ruling.