When taxpayers prepare their annual income tax return, they must include all taxable income generated for the tax year they are filing. This holds true, unless the income is excluded by a specific provision of the Internal Revenue code. Section 104 (a) (2) states a way in which income generated from damages can be excluded from gross income.
To be eligible for exclusion under the Internal Revenue Code, the income must have been received due to personal physical injuries or physical sickness. The damages are not excluded if they are punitive damages or have no physical component.
If damages are received by a taxpayer due to a settlement agreement, the nature of the claim will determine whether they can be excluded or not. If the settlement does not explicitly state the nature of the claim, the court will look at all facts and circumstances to determine the nature of the claim.
A recent Tax Court case was about a taxpayer who entered into a settlement agreement with multiple defendants and tried to recover damages sustained from a fire that destroyed his bee farm (Kenneth R. Harris v Commissioner). Kenneth Harris and another plaintiff alleged that there was negligence due to the defendants that caused:
- Physical and emotional suffering, as well as nervous pain
- Impaired earning capacity
- Destroyed business and business facility (note: not a physical personal injury)
- The loss and continued loss of use of his bee keeping facility
Harris received a check for $577,069 for his share in the settlement, and maintained that the proceeds were not taxable under the Internal Revenue Code Section 104 (a)(2). The IRS disagreed.
The Tax Court held that the agreement between Harris and the defendants lacked an express statement of the nature of the claim; they must look into the intent of the payer, and consider the details surrounding the lawsuit. The Court found that the complaint and the circumstances surrounding the lawsuit demonstrated that the settlement amount was paid to compensate Harris for property damage and the loss of income suffered due to the fire. Harris was unable to prove that the settlement was intended to compensate the physical injuries he claimed. Therefore, the entire settlement amount is considered taxable income.
Tax settlement proceeds should be included on prepared income tax returns in the gross income of the taxpayer. The only exception to tax settlement proceeds being excluded is if they were received due to physical injuries and physical sickness and a few other limited instances. The IRS will require that the taxpayers prove that the settlement income is to compensate for physical injuries or sickness to be excluded under Section 104 (a)(2)