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Tax Court: No Tax Exemption for This Legal Settlement

The taxpayer failed to report any of the $700,000 payment as taxable income on his return. So the IRS stepped in and the case ended up in the Tax Court.

If you receive an award or legal settlement relating to a personal injury or illness, you normally don’t owe any federal income tax on the payment. However, as pointed out in a new case, Roman (TC Memo 2023-142, 11/28, 23, Uncle Sam may still be entitled to his fair slice of the pie. 

Background: Most types of compensation—like wages received for working—are subject to federal income tax. But amounts received as compensation for personal physical injuries or illnesses are generally exempt from tax. This includes legal judgments or awards resulting from personal injury lawsuits.

Nevertheless, tax is imposed on several types of settlements where an individual has suffered harm. A few common examples are as follows.

  • Punitive damages:Punitive damages are intended to punish someone for their behavior rather than compensating another person for their injuries or illnesses. Thus, any potion of a legal settlement attributable to punitive damages is taxable.
  • Emotional distress: Amounts paid for emotional distress that don’t stem from a personal injury or illness is subject to tax. This issue is frequently litigated in the courts.
  • Non-physical injuries: Compensation for non-physical injuries—including discrimination, defamation and invasion of privacy—is generally taxable, unless specifically exempted under the tax law.
  • Structured settlements:  In some instances, a personal injury settlement may provide structured payments instead of a lump-sum distribution. The tax treatment for these settlements depends on the language of the settlement, including any allocation representing payment for physical injuries or illnesses.

Facts of the case: The taxpayer is a disabled individual with various other health problems. Although he is divorced, he has continued to live with his wife, who serves as his caretaker.

The couple entered into a lease agreement for an apartment in Los Angeles. The agreement included a caregiver addendum giving certain rights to the couple. The building owner agreed to these concessions.

Shortly after moving into the apartment, the couple started making complaints about the property, including expressing concerns about noise and harassment and submitting requests for accommodations in connection with the taxpayer’s disabilities. The owner gave the couple notice to terminate their residency due to their claims. Various legal actions ensued.

With the lawsuits still pending, the building owner decided to sell the property. However, when the potential buyer got wind of the issues relating to the taxpayer’s claims, he balked—even threatening to walk away from the deal at one point. 

Eventually, the owner and the couple reached a settlement where the couple agreed to vacate the building in exchange for a payment of $700,000. The settlement didn’t  cite any reasons for the payment. It simply contained a clause stating that there was no admission of fault or liability on the part of either party.

The taxpayer failed to report any of the $700,000 payment as taxable income on his return. So the IRS stepped in and the case ended up in the Tax Court.

Tax result: After examining all the facts and circumstances, the Tax Court determined that the entire $700,000 constitutes taxable income to the taxpayer. Based on the language in the settlement, it was abundantly clear that the owner intended to compensate the taxpayer for moving out—not for any physical injury or illness.