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Personal Injury Awards: 104(A)(2)
Should Personal Injury Awards Be Taxed?
Student Paper by Lyle Foster
Univ of Arkansas at Little Rock School of Law
Discussion of various tax policy arguments concerning the exclusion of
personal injury awards from income-taxation. Points of discusson
include humanitarian aid, the "return of capital" approach, as well as
potential abuses. This paper also addresses ancillary considerations
for the exclusion and possible reforms.
Table of Contents
Justifications for Retaining Exclusions
Internal Revenue Code 104(a)(2) fn1 excludes from gross income amounts
received frompersonal injury awards. It provides that:
"[e]xcept in the case of amounts attributable to (and not in excess
of) deductions allowed under 213 (relating to medical, etc., expenses)
for any prior taxable year, gross income does not include - . . .
(2) the amount of any damages received (whether by suit or agreement
as lump sums or as periodic payments) on account of personal injuries
or sickness . . . . " fn2
It was included in the original codification in 1918, and is about as
old as the federal income tax system. fn3
Although the provision has undergone little change since it was
enacted, it has caused much controversy in the courts and among legal
commentators. The courts have had to create distinctions to determine
what constitutes a personal injury as well as what part of the award,if
any, is attributable to a personal injury. In fact, it is often
difficult to classify the awards as excludable or includible. Legal
commentators argue that the legislatively enacted exclusion is not
within current tax policy and it should be repealed. The purpose of
this paper is to delineate the arguments for and against the exclusion
of personal injury awards. The last section will also discuss proposed
reforms generally. This paper will be limited to the issue of
compensatory damages. Punitive damages are unsettled in this area, and
to discuss them would go beyond the scope of this paper.
II. JUSTIFICATIONS FOR RETAINING EXCLUSION
The justifications for excluding personal injury awards are based on
several sound policy grounds. Like most policy arguments, these are
not free from flaws. The overwhelming support for exclusion are based
on the theories of humanitarian aid and return of capital.
Almost everyone would consider, at least arguably, that to confer a
benefit upon a person who has suffered a severe loss helps satisfy our
need to give humanitarian aid. In fact, more than one commentator has
made the observation that 104(a)(2) and its predecessors are rooted in
public policy grounds rather than strict logic. fn4 Others have gone
as far as to say that "taxation of recoveries for pain and suffering
would be offensive because the victim is more properly pitied than
taxed." fn5 "Commentators, however, are only following a line of logic
that originated elsewhere.
Several opinions have stated that Congress, by enacting 104(a)(2),
intended to confer humanitarian aid to the injured party. The
discussion of this topic in court decisions is usually centered around
whether the jury should be instructed as to the excludability of the
award. Even so, the reasoning of the court is still based upon
Congressional intent. The Supreme Court of Illinois in Hall v. Chicago
& Northwestern Railway Co. fn6 observed that "if the jury were to
mitigate damages . . . by reason of the income tax exemption . . . then
the very Congressional intent of the income tax law to give the injured
party a tax benefit would be nullified." Similar reasoning can be
found in Epmeier v. United States, fn7 Where the court found that
104(a)(2) was undoubtedly intended to relieve the taxpayer of a burden
when becoming injured or ill.
This humanitarian aid reasoning seems to be an extension of what our
human nature would like us to do. It is analogous to the exclusion of
life insurance proceeds from income tax. fn8 We feel an obligation to
help people in their weakest moments.
Probably the most common argument in favor of exclusion is the return
of capital theory. This encompasses the tort theory of placing an
injured party in as good a position as he would have been, had he not
been injured. The general idea is that damages only restore the
injured party to his original state. At first glance, it seems only
fair that we should tax the injured party's recovery of lost earnings
because we are only giving him what he otherwise would have been
taxable. But, the return of capital theory strikes at a deeper cord.
We are in essence stating that the damage award is compensating the
injured party for the loss of a capital asset, namely the ability to
earn. When the injury compensates for a lost limb, the rational behind
this policy makes logical sense. It is easier to visualize that in
this instance, the tortfeaser is paying for a "capital asset" of the
This exclusion precedes the enactment of 213(b)(6) of the Revenue Act
of 1918, the first codification of this exclusion. In 1915, the
Internal Revenue Service ("Service") ruled that proceeds received from
insurance on account of an accident were taxable. From this, it only
seemed reasonable that settlements from tort claims should also be
taxable. However, shortly after this ruling, the Supreme Court decided
four cases fn9, that distinguished taxable income from nontaxable
return of capital. In the wake of these cases, especially Doyle v.
Mitchell Bros. Co. fn10, the Attorney General discussed the issue of
proceeds from accidents by stating: "Without affirming that the human
body is in a technical sense the 'capital' invested in an accident
policy, in a broad, natural sense the proceeds of the policy do
substitute, so far as they go, capital which is the source of future
periodical income. They merely take the place of capital in human
ability which was destroyed by the accident. They are therefore
'capital' as distinguished from 'income' receipts. fn11 Shortly after
this announcement, the Commissioner adopted the same position and
allowed the exclusion of personal injury awards. Fn12
The loss of a limb provides a good illustration of the return of
capital theory, if it is a valid theory, of course it should be
applicable where no limb is lost because it is the ability to earn upon
which this theory focuses. With the focus on this ability, the theory
can be justified on the reasoning that there can be no taxes due
because there is no way to compute gain. If in fact the ability does
resemble a capital asset, what is the basis on which to compute gain?
Without a way to determine the taxpayer's basis in the asset, no gain
can be realized or taxed. This argument is known as the "lost asset"
approach and was advanced in Solicitor's Opinion 132. fn13 Solicitor's
Opinion 132 goes even further to state that these are personal rights,
are non-transferrable and as such, have no market value. Fn14
It could be said that Solicitor's Opinion 132 approaches the problem
incorrectly because in dealing with capital assets, we are not
concerned with the market value, only basis. fn15 And since there is
never a monetary amount credited to a capital account for a human body,
the basis is zero. However, if the ability to earn is a capital asset,
we must fully allow it all the characteristics of a capital asset. In
so doing, most expenditures that further the ability to earn (capital
asset), should be added to the basis. This could include things such
as food, education and health care. fn16 " With this daily adjustment
to the basis, even starting at zero, the basis would quickly rise. In
fact, if a basis could be determined by this method, it would appear
that most personal injury awards would be less than the basis and a
capital loss would be appropriate.
Case law furthers the rationale of the return of capital theory. In
Hawkin v. Commissioner., fn17 " the holding allowed the exclusion based
on the theory that the money award only returned the injured party to
the position he would have occupied. Then, in Glenshaw Glass v.
Commissioner, fn18 the Court's decision classified punitive damages as
taxable in some situations, of which there is still some uncertainty.
However, the point at issue there was that the Court noted that
personal injury awards were not taxable on the theory that they
corresponded to a return of capital and that they were by definition,
compensation only. Fn19
"Eisner v. Macomber fn20 " supports the "lost asset" approach
indirectly. The whole underlying policy for that approach is that the
proceeds are not income because there is no way to compute gain. This
is slightly, if at all, different from the return of capital theory,
which focuses on compensation for the lost ability. This discussion
will treat the "lost profit" argument as a subset of the return of
capital. Eisner dealt with the ability to tax stock dividends as income
and was decided under different circumstances. However, the court held
that income is "derived from capital, from labor, or from both
combined; something of exchangeable value . . . ." fn21 Without a way
to determine an exchangeable value, there can be no gain and hence no
III. JUSTIFICATION DEFECTS
All the policy reasons above have flaws. Some are more refutable than
others. In addition to the direct opposition to the above reasoning,
there are additional questions about the exclusion. These include the
inability to find Congressional intent and potential abuse in
structured settlements. Before discussing the answers to the arguments
favoring the exclusion, it is necessary to understand the legislative
From the inception of the exclusion, there is very little Congressional
history upon which to base policy. This by itself could lend itself to
an argument that the exclusion is not being overlooked. By the mere
avoidance to address the issue, Congress is expressing it's intent by
allowing the courts to interpret. However, upon reviewing the
legislative history of the act, there seems to be only one reference,
and it does not deal with policy: "Under the present law it is doubtful
whether amounts received through accident or health insurance, or under
worker's compensation acts, as compensation for personal injury or
sickness, and damages received on account of such injuries or sickness,
are required to be included in gross income. The proposed bill provides
that such amounts shall not be included in gross income. fn22" With
this little amount of history, the courts that interpret the
"Congressional intent" are only guessing. If the directive were clear,
maybe no Congressional intent would be needed, but courts are having a
difficult time construing exactly what is meant. Further, since there
is an absence of expressed intent, the courts are obviously
interjecting their own policy reasons, not the stated policy reasons
for the exclusion's creation.
Aside from the fact that the legislative policy reasons are a bit
scant, there are also serious defects in the general policy that
supports the exclusion, such as the humanitarian aid argument. It
would appear obvious that any civilized community would like to help
those who have been injured. However, if this is our true policy for
keeping the exclusion, it is not administered fairly to all those who
should be entitled. From the exclusion itself, one who recovers an
award through the tort system, be it by suit or agreement, is given a
tax benefit. This does not however, give humanitarian aid to all those
who have suffered. The vast majority of personal injures are never
compensated. Therefore, the only victims who receive a tax benefit are
those who take some successful action through the tort system. If we
are in fact basing our exclusion on humanitarian needs, there should be
a deduction allowed to those who do not recover tort proceeds.
We have also limited our exclusion to a class of people who receive
benefits through the tort system. We do not allow any benefit to those
who have accidentally injured themselves. We also do not allow any
relief to those who suffer an illness not due to the fault of another.
Clearly, each of these persons have had their ability to earn impaired.
But, they do not fall in the correct class to receive a benefit. Here
again, if we were to be basing this exclusion on humanitarian aid,
these people would surely be entitled to a benefit, such as a
The second policy reason advanced above dealt with the return of
capital theory. This argument must first be analyzed in light of what
capital is actually being returned. The argument that we are, by
awarding an injured party compensation, making him "whole again," does
not equate to a return of capital. It does not equate on a conceptual
basis, nor does it follow case law.
To accept the return of capital argument, there must be a basis in the
so-called capital. The thought that a basis could be established by
expenditures for food, shelter and the like, is inhibited by the
ability to do such a task. No one keeps track of these outlays to the
extent necessary to determine a basis. But, assuming arguendo that
records have been kept, most of these outlays are nondeductible
personal expenditures. fn23 And, by what means are we to establish
what is classified as a personal expenditure and what is a capital
expenditure? What possible system could tell us whether (or what
portion), we should allocate clothing, food, shelter, etc. to capital
expenditures? Could we include transfers from others, like parents or
the government? fn24
Although there are technical difficulties, one might argue that the
basis could be inferred from the amount received. fn25 This would be
similar to the proposition that when the fair market value of an asset
exchanged cannot be determined, it is assumed to equal the value
received. fn26 Being similar to an accepted principle does not make
this proposition acceptable, though. This basis equal to recovery
argument does not even approximate recoveries allowed for small
children. It is also inconsistent with other human capital doctrines.
fn27 If one does in fact have an investment in human capital, an
allowance for depreciation should be given. fn28 This allowance would
be consistent with a treatment of the compensation as return of
capital. This enactment would also take an affirmative stamp on the
part of Congress and would allow us to truly understand what their
policy reasons for the exclusion are. As mentioned above, it would
also seem necessary to allow deductions for uncompensated injuries and
accidents. fn29 If this lost ability to earn is capital, the
uncompensated impairment of that ability should be treated as a tax
loss, especially if we treat compensation for that lost ability as
It also appears that to classify a personal injury award as a return of
capital would be misleading compared to what is actually being awarded.
A personal injury award does not actually claim to pay for a lost limb
or the lost ability to earn. Instead, compensation is awarded for
medical expenses, pain and suffering and lost earnings. fn30 Although
lost earnings may closely equate to lost ability, they are not the
same. More accurately, the lost ability is considered to determine the
amount that will not be earned. If it had been earned, it would have
been subject to income tax.
Theoretical concepts are not the only areas in which the return of
capital theory is disputed. The case law that is often cited as
judicially interpreted policy may be misinterpreted. The two landmark
cases supporting the exclusion of physical personal injury awards due
to the return of capital theory, are not concerned with physical injury
at all. While these two cases further the argument for exclusion for
the return of capital, they concern property in which there is a
determinable basis. Commissioner v. Glenshaw Glass fn31 dealt only with
the issue of punitive damages in a business antitrust action. This
case held that the return of capital rationale does not apply to
punitive damages recovered in an injury to property. From this, it
could be argued that the exclusion of compensatory physical personal
injury awards can be based on the return of capital theory. But
Glenshaw Glass had nothing to do with physical injury. This case dealt
with injury to property, the basis of which can be determined. The
same can be said for Doyle v. Mitchell Bros.Co, fn32 which dealt with
the taxpayer's receipt of his original investment in the resale of
The above discussion leads to the conclusion that the exclusion of a
personal injury award cannot be supported as a return of capital on a
literal, conceptual or case law basis. With this as a starting point,
the exclusion lends itself to a number of other policy defects. If the
compensation is in fact to replace earnings, it should be taxed because
the earnings would be. A discussion of when it should be included will
be addressed below. The reason it should be included is based on
horizontal equity. Those with equal incomes should be taxed equally.
The award is not a return of capital and so it should be classified as
income, subject to tax. To hold otherwise creates a tax subsidy to the
injured party. It is a Congressional decision to exclude income that
would otherwise be taxable.
Structured settlements are a creation of the personal injury exclusion
and have great potential for abuse. The issues involving structured
settlements go beyond the scope of this paper. However, there are some
concerns of the exclusion's ability to induce abuse. The first
concern is the ability of structured settlements to produce an interest
component that is never taxed. By the nature of the settlement, a
certain amount is set aside to produce interest. Then each period the
injured party is paid a portion of the award plus interest. Because
periodic payments are excluded from tax, the interest component is
never taxed. fn33 Since the payor can give less to satisfy the injured
party, this gives the payor a leveraging tool for settlement. But, to
forgo taxing the interest component is clearly at odds with horizontal
A second abuse in structured settlements is the ability to represent
the facts as a personal injury rather than contractual breech. Since
personal injury is excluded from tax and contractual recoveries are
not, it is to the benefit of both parties to agree the damages are
personal. The distinction between the two types of claims can be
slight. This creates a problem of policing excludable injury from
contractual loss. fn34 While there is a judging standard to try to
distinguish the two, there is no way to do so with assurance. Validity
of a claim is not important, fn35 only the classification.
IV. ADMINISTRATIVE ANCILLARY CONSIDERATIONS
In addition to the above pro/con policy concerns, there are at least
four ancillary considerations. While obviously the return of capital
theory remains a pivotal point, administrative procedures must come
into play. These administrative concerns include the ability to
determine the amount to be taxed, taxing the "pain and suffering"
element, if the tax is "fair" and retaining the status quo. These
considerations are not without flaw either. Section IV(a) will offer
the arguments for exclusion, while IV(b) will refute.
At a minimum, the "lost profit" element of compensatory damages should
be taxed. Everyone who does earn a profit or has income, fn36 is
subject to tax. Why not tax the "lost profit" element of a personal
injury award? An argument to exclude even the "lost profits" portion
of the award can easily be made due to administrative
impracticability. To support taxation of the "lost profit" we must
determine its amount. Juries do not usually assign an amount for each
element. fn37 " And even if they did, do we allow them to make an even
more arbitrary determination of the "lost profit" element? If so, then
we are making the jury more than a "fact-finder." Not only would the
parties have to prove damages, they would also have to prove by highly
technical means how much of that award should be attributed to "lost
profit." Assuming the case does not go to trial, but a settlement is
reached, the settlement agreement may be just a waiver of claims
without specifying what the compensation is being given for, making it
difficult to assign a "lost profits" element. Lastly, even assuming
that the "lost profits" element could be broken out in most torts, it
would be almost impossible to do so in the case of certain torts such
as defamation. The damages may only be representative of one's
impaired reputation, not personal harm or "lost profit." fn38
The second ancillary consideration has to do with "pain and suffering,"
a traditional element of tort damages. What argument can the
government make that it is entitled to tax those proceeds? Surely we
would not be led to believe that because the injured party received an
award, he was a wage earner being paid by the hour for pain. A big
fear of the Government's would also be the media coverage it would
receive if it were to attempt to tax this element. Even if a sound
policy exists for taxing "pain and suffering," it is not the kind of
publicity the Treasury Department desires. fn39 Assuming that a sound
policy reason does exist, there would be no way to explain it in a way
that the American people would understand and support.
Insurers are also not in favor of taxing "pain and suffering," or any
other element of damage. They believe that to tax the damage award
would lead to substantially higher jury verdicts. fn40 While insurers'
concerns may not be a sound tax policy on which to base a decision, it
does lend itself to modern concerns. The vast majority of people
believe there are too many frivolous law suits filed, and bigger jury
awards would certainly increase the likelihood of filing. In addition,
the insurer does not absorb the ultimate cost of lawsuits, it is the
shareholders and policyholders. To allow taxation of damage awards
would not effect insurers as much as it would increase shareholder and
Another consideration is the general idea of fairness. Personal injury
awards are, in effect, unwanted income. Given the alternative, most
people would have opted not to have been injured. To tax these
proceeds would be adding the so-called "insult-to-injury." It should
not be within our sense of fairness to tax income that arose by an
involuntary act of a victim. fn41
A second fairness argument arises out of "bunching." A lump-sum
personal injury award is more likely to be uncharacteristic of what the
victim's "normal" yearly income would be. Even structured settlements,
with the payout over a number of years, are probably greater than the
"normal" yearly income of the victim. To tax these proceeds in a
single period would subject the victim to a much higher tax
responsibility than would have occurred over the period of compensation
for which he is being credited with earning it. To satisfy the need to
lower the tax responsibility, some type of income averaging would have
to be devised. However, income averaging violates not only the
accountant's theoretical view of "recognized when realized" for a cash
basis taxpayer, it is also inconsistent with the principles of I.R.C.
The last argument is status quo. This is the inverse of the "old taxes
are good taxes" argument. While this argument is applicable to a
number of taxes and tax exclusions, there are few to which it is more
truly applicable than to the exclusion of personal injury awards. This
exception started before the first I.R.C. codification in 1918. This
tax exclusion has, for all practical purposes, been in existence since
the organized tax system began. This exception is relied upon daily in
These four ancillary policy considerations can be criticized. The
easiest way to cure the inability to tax the "lost profits" element of
the award is to subject the whole award to tax and then allow medical
deductions for expenses paid. fn43 If it is deemed desirable to
exclude all portions of the award except the "lost profits" element, an
allocation method can be devised. This allocation method would come
into effect in some jury awards and probably all settlements. This is
because allocation by a jury is probably conclusive, but allocations in
settlements are not. fn44 That is not to say that jury awards are
conclusive, but the review would be limited to reasonableness. Creation
of one more allocation would not cause many problems. Our tax system is
full of hypothesized allocations now. fn45 There is even one
allocation, the amount of punitive damages, already in place in the tax
treatment of personal injury awards. fn46 The punitive damage element
must be broken out due to the possibility that it may be taxable. fn47
The government has created a "facts and circumstances" fn48 " test to
determine taxability of punitive damages and a similar test or
allocation method could be created for "lost profits."
The emotional attack on taxing compensation, especially "pain and
suffering," may be compassionate, but it is not sound policy. The
concern over media coverage and the possibility of increased exposure
by the indemnifier has no place in sound policy decisions. Taxes are
not popular. Little coverage by the media will be favorable to either
increased taxes or expanding the tax base. As far as increased
exposure, those costs can and are passed on to those who cause the
If the concern is based on the idea that we are taxing "pain and
suffering," one way to alleviate that is to tax only the "lost profits"
element. However, the "pain and suffering" element is compensation.
It meets the definition of I.R.C. 61 income as "[any] income from
whatever source derived." The idea that those not compensated should
be entitled to a deduction might make theoretical sense, but it would
be impractical to administer. Further, just because we do not allow a
deduction for those not compensated does not justify the proposition
that we should not tax those who do.
Justifying the taxing of unwanted income appears unfair. However, to
some extent the injured party has control over what damages he seeks.
Albeit a bit unrealistic, if he does not want the "lost profits"
element, which is most closely associated to taxable income lost, he
does not have to ask for it. In addition, there are many similar areas
where "lost profits" are compensated and are not excluded, like
unemployment income and sick pay. fn
There is a valid argument of fundamental unfairness concerning bunching
of income. A personal injury award would subject the injured party to
a higher tax liability than if he paid the tax in the period recovered.
The bunching of income argument is not unique to personal injury awards
and there are alternatives that will be discussed below. Even if there
were not, with current tax rates, the additional liability is not
great. The tax rates are almost flat now. fn50 Litigants could deal
with this problem through structured settlements. Structured
settlements could allow taxation on the amount received for that
period, eliminating bunching in one year. fn51 " It would also be
possible to allow the injured party to choose how much money he wishes
to receive in each period. This would give him the control over the
tax liability. If a structured settlement is not created, income
averaging is still possible.
The final ancillary policy consideration cannot be measured against tax
policy. Old taxes may be good taxes, but exclusions that are unfair to
taxpayers as a whole are not "good." If it is sound policy to include
personal injury awards, then to keep them excluded on the basis of
history would do little to support confidence in our tax system.
V. POSSIBLE REFORMS
The above discussion outlines the competing interests involved in
excluding personal injury awards. So, what can be done? Since the
current law excludes, the only reform is to include. The remaining
problems concern what to include. Which parts of the award are
justifiably taxable, and how do we classify them? The two proposals
suggest taxing the entire amount with exclusion of medical expense
under I.R.C. 213 or taxing only economic proceeds (lost profits).
Once one of these proposals is adopted, there still must be a
determination on whether to tax the awards as ordinary income or
capital gains. While each of the foregoing proposals have all of the
policy pros and cons delineated above, the focus of the discussion
around the proposals will highlight only the most important
considerations. It will also be assumed that where proceeds are taxable
as ordinary income, some action has been taken to alleviate "bunching."
In case of structured settlements, the "bunching" is easily taken care
of by taxing the portion of the award when received.
The first alternative would include all proceeds. Medical deductions
would be allowed under I.R.C. 213. The advantage of this type of
adjustment is that it would be easy to administer. It would be
unnecessary to distinguish between physical or nonphysical, contract or
tort. Conceptually, all should be included. This would meet the
definition of I.R.C. 61 income as well as meet the Glenshaw Glass
definition of accession to wealth, clearly realized over which the
person has dominion and control.
The drawback of this type of plan is that it may unfairly subject the
injured party to a greater share of the burden of costs and fees, in
the American court systems, the parties must bear their share of fees
and court costs. Since many personal injury cases are contingent, the
injured party may never receive a large share of the award. Even
though the injured party never receives it, under this system, he must
still pay tax on it. While that is attributable to the American system,
it seems unfair due to the fact that this was an involuntary act on the
part of the injured party. If we assume that the whole award is being
taxed because the income that would have been earned would have been
taxed, we will have levied a penalty on the injured party for asking
what he would have been entitled to had he not been injured. After tax
dollars should not have to be used to pay for expenses that were
causally linked to another party. We could allow deduction for certain
fees, but that would defeat the real strong point of this system,
The same argument could be made for the "pain and suffering" element
since it will be subject to contingency fees as well. Taxing this
amount is at the root of the unfairness argument. This would be levying
a tax on the arbitrary dollar value assigned to a person's pain. That
thought seems inconsistent with the concept of fair play. The idea that
an award takes the place of freedom from pain, which is not taxed, is
preposterous. If not, a tax would have to be levied against those who
have suffered uncompensated pain. This in essence, would mean pain,
regardless of whether compensated or not, is taxable.
An alternative argument is if we were to tax the "pain and suffering"
element, we should allow a deduction to those who went uncompensated.
This would be the reverse argument to taxing people on how well off
they are. If the tax system collects for the personal injury award
element of "pain and suffering" because the taxpayer is better off, the
only reason they are is because they received an award for their pain.
Therefore, those who do not, are worse off. A system of deductions
would have to be established for different types of pain. This would
have to be detailed to show consistency. What amount is proper for
pulling a tooth? Even worse, how will the Service police establishing
Another fairness argument is that the injured party is penalized for an
injury that is another's fault. If we tax an award for medical
expenses and then allow a deduction under I.R.C. 213, this still does
not allow the injured party to be placed back in the position he was
prior to the accident. This is because medical deductions are only
allowable to the extent they exceed 7.5% of adjusted gross income. fn52
While this type of limitation may be fair for routine medical expenses,
it is not fair to require a party injured by another to pay the
additional tax. The injured party would not be in a position to need
medical help but for the actions of another, so why penalize him? For
these reasons this method is unacceptable. It we do decide to tax the
medical expense portion, fairness would dictate allowing a full
deduction for medical costs incurred in the personal injury. This may
lead to further problems in determining which personal injury medical
expenses are attributed to acts of others.
A second idea is to exclude all non-economic proceeds. This correlates
to the idea of taxing "lost profits," and would exclude the damages
awarded for medical expenses and "pain and suffering." The "lost
profits" would be treated as ordinary income. With this proposal comes
the "bunching" concern. It would be possible not only to average
income, but in the alternative it would be possible to include only a
portion of the award. It is not clear what theoretical viewpoint is
advanced in only including a portion, but it does deflate the argument
Including only the "lost profits" element more closely resembles what
would have been included in the tax base. It would be fairly simple to
administer by using whatever reasonable calculations the parties used
to determine what in fact was the amount lost in earnings and earnings
capabilities. It might even be appropriate to require, or at least
recommend, that the amount classified as "lost profits" be approved by
a judge or contained in the settlement agreement. Since this proposal
excludes the "pain and suffering" element, it still has an emotional
ring. That is the element of "pain and suffering" is the portion of the
award that was "unwanted." There is also case law that suggests that
this portion of the award cannot be taxed. Starrels v. Commissioner
fn53 held that "pain and suffering" represented a restoration of basis.
While the arguments above clearly show the flaws in the return of
capital theory as a basis for exclusion of the whole award, the
exclusion of "pain and suffering" on these grounds would be the easier
of the three elements to justify.
The principal complicating issue involving this type of arrangement is
administrative practicability. There may still be some trouble in
determining which part of the award most fairly represents the "lost
profits" element. With the adoption of another test, numerous
lawsuits will have to be heard to determine where arbitrary limits will
be placed unless allocation is set by statute. However, if allocation
is by statute, problems will arise due to inflexibility in specific
cases. To base the determination on a formula would be too strict and
unyielding to individual situations. While literally, the exclusion of
the "pain and suffering" element does not square with the complete
definition of I.R.C. 61 and Glenshaw Glass, the Code already
recognizes many. fn54 Congress has been empowered to exempt even those
things that otherwise would be included. If there is to be a change in
the current law, this is the better alternative.
Another way to combat the "bunching" argument from the last proposal
would be to treat the "lost profits" element as capital gains. Since
the concept of capital gains is in itself a legal fiction, created by
being in a class not otherwise prescribed, the inclusion of this
element would only add another inclusion by exclusion of I.R.C.
1221.fn If the argument that the award is based on a return of
capital theory does in fact have merit, perhaps this is the best way to
treat the "lost profits" element. The strength in this proposal is that
it would alleviate the "bunching" problem. Offsetting deductions for
capital losses would be allowed, as well as, however slight, potential
preferential tax treatment. fn56
Putting aside further pros and cons concerning whether any part of the
award is a return of capital, there is still doubt as to whether this
treatment would alleviate "bunching." While it may be true that some
injured parties who recover a personal injury award get to take an
offsetting capital loss or get a slight preferential tax treatment,
this would not be true in most cases. For the most part, both of these
benefits help wealthier people. They are the most likely people to have
capital investments that generate capital losses. Further, any
preferential tax treatment would only go to those who are in the
highest tax bracket. This type of anti-bunching proposal would only
increase the regressivity of our tax system.
Obviously unsettled, this area remains a focal point of commentators'
criticism. There is policy in support of excluding personal injury
awards that makes logical sense. We all would like to give a person
who has suffered a loss a helping hand, and there are various fairness
arguments against taxing certain elements of the award, especially
"pain and suffering." However, the current exclusion is far from
meeting our policy goals. It is not representative of what our tax
system should be. These proceeds, at least in part, fully meet the
definition of income. There is also unfairness to taxpayers in general
to be paying for some of the costs of this tax exclusion as a subsidy.
There does not seem to be a right, or easy, answer.
The best way to accommodate both interests would be to tax the "lost
profits" element of a personal injury award. The arguments for
exclusion are much stronger if limited to the "pain and suffering"
element and medical expenses. Of course, a suitable income averaging
plan would have to be devised. From a conceptual standpoint, the
amount of the award is to compensate for a certain period of time. In
addition, averaging is necessary to give an accurate account of what
the injured party's tax would have been. The capital gains approach
would not be sufficient. It gives preferential treatment to those with
higher incomes. Structured settlements would have their income
averaging plan contained within the settlement.
1 Unless otherwise stated, all references to I.R.C. are to the
Internal Revenue Code of 1986, as amended.
3 See Ralph S. Rice, Federal Income Taxation 2 (1967). The federal
income tax system dates back to 1913 when the Sixteenth Amendment was
4 See Note, Taxation of Damage Recoveries from Litigation, 40
CORNELL L.Q. 345, 346 (1945-1955)(stating that the notion behind this
justification is the desire to relieve an injured person, who has
suffered enough, from both tax and the burden of allocating a recovery
between taxable and tax exempt components); Harnett, Torts and Taxes,
27 N.Y.L.U. REV. 614, 626-627 (1954) (noting that a tax treatment of
personal injury recoveries is more likely based on humanitarian aid and
less legalistic notions concerning good policy).
5 Comment, Tax Treatment of Post-Termination Personal Injury
Settlements, 61 CAL.L. REV. 1237, 1237 (1937).
6 5 Ill.2d 135, 125 N.E.2d 654 (1953).
7 199 F.2d 508 (7th Cir. 1952).
8 I.R.C. 101(a)
9 Lynch v. Hornby, 247 U.S. 339 (1918); Southern Pac. Co. v. Lowe,
247 U.S. 330 (1918); Lynch v. Turrish, 247 U.S. 221 (1918); Doyle v.
Mitchell Bros. Co., 247 U.S. 179 (1918)
10 247 U.S. 179, 184 (1918).
11 31 Op. Att'y 304, 308 (1918).
12 T.D. 2747, 20 Treas. Dec. Int. Rev. 457 (1918).
13 I-1 C.B 92 (1922).
15 I.R.C. 1001(a) Basis is determined by costs derived from
nondeductible capital expenditures or income inclusions with respect to
the asset itself.
16 See Paul B. Stephen, III, Federal Income Taxation and Human
Capital, 70 VA. L. REV. 1357 (1984).
17 40 B.T.A. 1023 (1927)
18 348 U.S. 426, 432 (1955).
19 Id. at 432, n.8; See 2 Cum. Bull. 71;I--1 Cum. Bull. 92,93; VII--
2 Cum. Bull. 123; 1954--1 Cum. Bull. 179,180. Damages for personal
injury are by definition compensation only. Punitive damages, on the
other hand, cannot be considered a restoration of capital for taxation
20 252 U.S. 189 (1920).
21 Id. at 190.
22 H.R. REP. NO. 767, 65 Cong., 2d Sess.9-10 (1918), reprinted in 94
INTERNAL REVENUE ACTS OF THE UNITED STATES 1909-1950 LEGISLATIVE
HISTORIES, LAWS AND ADMINISTRATIVE DOCUMENTS 9-10 (B. Reams, Jr. ed.
23 Treas. Reg. 1.262-1(b) (1958).
24 See John K. McNulty, Tax Policy and Tuition Credit Legislation:
Federal Income Tax Allowance for Personal Costs of Higher Education, 61
CAL. L. REV. 1, 26-27 (1973).
25 Cf. Inaja Land Co. c. Commissioner, 9 T.C. 727 (1947), acq.,
1948-1 C.B. 2.
26 See Philadelphia Park Amusement Co. v. United States, 126 F.
Supp. 184 (1954).
27 Joseph W. Blackburn, Taxation of Personal Injury Damages:
Recommendation for Reform, 56 TENN. L. REV. 661, 663-668 (1989)
28 This in itself might be difficult since a basis to depreciate
must be determined. However, more Government tables could be produced.
But if so, where do we get basis from? age? education? race? domicile?
sex? Do all these factor a person's inherent worth or their ability to
29 Here again an arbitrary amount must be determined using possibly
the same factors as stated in 28 and adding others. To determine the
amount of deduction, the pain and suffering factor must be added to the
above factors, time of impairment and maybe lost opportunities.
30 See RESTATEMENT (SECOND) OF TORTS, 901-932 (1977).
31 348 U.S. 426 (1955).
32 247 U.S. 179 (1918).
33 I.R.C. 104(a)(2).
34 Bolla, Contort: New Protector of Emotional Well-Being in
Contract, 19 WAKE FOREST L. REV. 561 (1983).
35 Seay v. Commissioner, 58 T.C. 32,37 (1972).
36 This is actually what the "lost-profit" approach is suggesting is
37 Verdicts do not require an itemization of amounts awarded under
FED. R. CIV. P. 46(b): see also Kalevity v. United States, 548 F.2d
809, 811 (6th Cir. 1978) (court rejected argument that any award over
and above actual loss is 'punitive' on grounds that traditional tort
law mixes theories of compensation and deterrence together when
awarding ordinary damages).
38 See Note, Roemer v. Commissioner: The excludability of
Nonphysical Tort Damages from Gross Income Under Internal Revenue Code
104(a)(2), 1985 UTAH L. REV. 477, 478 n.7 (citing L. ELRIDGE, THE LAW
OF DEFAMATION 2 (1978)).
39 Lawrence A. Frolik, The Convergence of I.R.C. 104(a)(2), Norfolk
and Western Railway Co. v. Liepelt and Structured Tort Settlements: Tax
Policy 'Derailed', 51 FORDHAM L. REV. 565, 591 (1983).
40 This issue was addressed in Norfolk & Western Railway Co. V.
Liepelt, 444 U.S. 490 (1980).
41 While taking part in a settlement agreement or filing a lawsuit
is a voluntary act, the reference to an involuntary act relates to the
42 I.R.C.451(a) provides that "[t]he amount of any item of gross
income shall be included in the gross income for the taxable year in
which received by the taxpayer, unless, under the method of accounting
used in computing taxable income, such amount is to be properly
accounted for as of a different period."
43 I.R.C. 213
44 See Phoenix Coal Co. v. Commissioner, 231 F.2d 240 (2d Cir. 1956)
45 See, e.g. I.R.C. 61,167 and 168.
46 Rev. Rul. 85-98, 1895-2 C.B. 51
47 I.R.C. 104(a) does include, at a minimum, the punitive damages
portion in a nonphysical personal injury suit.
48 See Roemer v. Commissioner, 716 F.2d 693 (9th Cir. 1983); Church
v. Commissioner, 80 T.C. 1104 (1983); Woodward v. Commissioner, 397
U.S. 572 (1970)
49 I.R.C.85 and 122(b).
50 I.R.C. 1
51 Structured settlements allow a portion of the total award plus
accrued interest to be paid the injured party over a certain number of
53 304 F.2d 574 (9th Cir. 1962), aff'g 35 T.C. 646 (1961).
54 I.R.C. 101-135
55 I.R.C. 1221 defines what assets will be treated as capital
assets. However, its definition does not tell what a capital asset is,
only what a capital asset is not.
56 I.R.C. 1(h) provides a limit on the amount of tax that can be
levied on capital gains of 28%. However, this limit is restrictive in
the fact that capital gains is taxed at the same rate as ordinary
income until the tax rate goes over 28%.
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