Are Court Awards and Settlement Proceeds Taxable?

An important issue in personal injury and economic damages cases is whether the plaintiff will owe taxes on the settlement proceeds or an amount awarded by the court.

Injured parties who are unexpectedly hit with a hefty tax bill might not be made "whole" again, as demonstrated by this recent U.S. Tax Court case. (Zinger v. Commissioner, T.C. No. 2018-33, July 2, 2018.)

Employee Battles Army

In 2011, Nicole Zinger worked for the U.S. Army. One night, she was in a car accident on her drive home from work. Zinger's injuries required physical therapy and her supervisor allowed her to classify the time she spend on treatments as sick time. That supervisor was reassigned in late 2011.

Zinger's new supervisor was unaware of her accident and he was stricter regarding time-off requests. After a two-week vacation, Zinger's grandmother fell ill and eventually died, requiring Zinger to take additional time off. When Zinger returned to work from her bereavement leave, her desk had been moved, isolating her from coworkers.

Zinger alleged that she often felt "belittled and personally attacked" by her new supervisor. She testified that, because of her interactions with the supervisor, "her heart began racing, she experienced shortness of breath, and she felt as though she might be having a heart attack."

In May 2012, Zinger's blood test revealed an elevated white blood cell count and she was placed on medical leave to determine her condition. When she returned to work she received a memorandum of reprimand from her supervisor for "discourteous behavior toward a supervisor." Zinger subsequently filed a formal written grievance to dispute her supervisor's memorandum. Her grievance listed Zinger's medical issues and conditions, including "chest pains, shortness of breaths, hypertension due to stress, high blood pressure, and high white blood cell count."

In June, Zinger took another medical leave to undergo additional testing. Her doctor identified her condition as anxiety, panic attacks and hypothyroidism. Her treatment included medication, rest and a stress-free environment. When Zinger returned to work in August she had lost her computer access and security clearance. She was required to sit at a desk with little work to perform.

Shortly thereafter, the U.S. Equal Employment Opportunity Commission (EEOC) began an investigation to determine whether Zinger was discriminated against based on sex and whether she was subjected to a hostile work environment. As a result, Zinger was placed on administrative leave while the EEOC conducted its investigation.

In January 2013, Zinger settled her EEOC complaint with the Army for $20,000. Pursuant to the settlement agreement, she resigned from federal service. The agreement didn't refer to Zinger's formal written grievance. It also didn't identify any of her personal injuries or sickness.

Complex Tax Issues

Based on the nature of Zinger's claims against the Army, she and her husband didn't report the settlement proceeds on her 2013 federal income tax return.

The IRS issued a notice of deficiency for the unreported settlement. The Tax Court turned to the settlement agreement to determine how to classify the settlement proceeds. The agreement indicated that its purpose was to settle the taxpayer's EEOC complaint. The EEOC statement of claims neither references any injuries or sickness nor allocates the $20,000 settlement payment as compensation to Zinger for any injuries or sickness.

Instead, the statement of claims explicitly states that the EEOC was investigating whether Zinger had been subjected to a hostile work environment or was discriminated against on the basis of sex. Therefore, the agreement suggests that the Army didn't intend to compensate Zinger for injuries or sickness.

Because the settlement agreement didn't reference 1) the taxpayer's physical injuries, 2) her written grievance against the Army, or 3) the EEOC complaint that listed her physical injuries, the court determined that the taxpayer didn't meet the required burden of proof. Therefore, the payment received pursuant to the settlement agreement wasn't excludable from the Zingers' gross income for 2013.

Lesson Learned

This case shows the importance of detailed settlement agreements. A defendant may not want to admit wrongdoing. But what's spelled in a settlement agreement provides evidence to prove whether the proceeds meet the requirements to be excluded from gross income. In this case, an ambiguous settlement agreement proved costly to the taxpayer.

Before settling a dispute, discuss potential tax issues with a financial expert to minimize the risk of IRS scrutiny.

Tax-free or Taxable

Under the Internal Revenue Code, payments received as compensation for physical injury or physical sickness are federal-income-tax-free. It doesn't matter if the compensation is from a court-ordered award or an out-of-court settlement — or if it's paid in a lump sum or installments.

Compensation for emotional distress that arises from physical injury or sickness is also tax-free. That's because the distress is considered part of the physical injury or sickness.

Amounts received for medical expenses are tax-free. But, if you claim a medical expense deduction for costs that are later reimbursed by an award or settlement, you must "recapture" any amount that's specifically allocated to medical cost reimbursements up to the amount you've previously deducted on your tax returns. When there's no specific allocation to previously deducted medical expenses, the payment is considered a reimbursement for such expenses up to the amount of those expenses.

Any amount allocated to interest for the period between the physical injury or sickness and the time you get paid is taxable. However, amounts paid for lost wages are federal-income-tax-free, even though the wages would have been taxable if you had received them.

Other types of settlement payments are generally taxable, including payments for legal (as opposed to physical) injuries caused by harassment, discrimination, wrongful termination, libel and invasion of privacy. The same is true for payments for emotional distress that's not caused by physical injury or sickness. In addition, payments for punitive damages (amounts paid for the specific purpose of punishing the wrongdoer) are generally taxable even if they're paid as compensation for physical injury or sickness.


LOUIS J. CERCONE, JR., CPA, CFE, CFF, ABV, ASA, CVA
lcercone@briscon.com

Lou is the Managing Director of Brisbane Consulting Group in charge of business valuations, forensic accounting, and litigation support services. He has extensive valuation experience and has served as a financial consultant and expert to attorneys in the economic aspects of matrimonial dissolution. He has been engaged in several forensic accounting cases and has served the judiciary as a court appointed expert and receiver for financially troubled companies. He has testified as an expert witness in State Supreme Court and Federal Court. Lou has also been engaged in the quantification of lost income in determining business interruption claims for insurance adjusters.