Recent Tax Court Case Shows When Settlement Proceeds May Be Taxable

Are settlement proceeds taxable? The U.S. Tax Court recently held that settlement proceeds received in a malpractice suit against a taxpayer's attorneys were, indeed, taxable. The attorneys had represented the taxpayer in an unsuccessful personal injury suit against a hospital. (Debra J. Blum v. Commissioner, T.C. Memo 2021-18, Feb. 18, 2021.)

The court's decision was based on two key assessments. First, the proceeds weren't received on account of physical injuries. Second, the court determined that the proceeds didn't qualify for an exclusion for a return of capital. Here are the details.


Under current tax law, damages taxpayers receive for personal physical injury or physical sickness are excluded from gross income. (See "To Tax or Not to Tax" at the bottom of the page.)

For taxpayers to fall within this exclusion, they must show that there's a direct causal link between the damages and the personal injuries sustained. When damages are received pursuant to a settlement agreement, a critical question is: "In lieu of what was the settlement amount paid?"

In addition, payments are excludable from gross income as a return of capital if they're to compensate for the loss or destruction of capital. An amount paid to a taxpayer to compensate the taxpayer for a loss caused by the erroneous advice of a tax consultant generally is a return of capital — and it's not includable in gross income.

Case Facts

In 2007, the taxpayer was admitted to a hospital for total knee replacement surgery. She was directed to sit in a wheelchair. But it was broken, causing her to fall to the floor and sustain significant injuries.

She filed a complaint, alleging that the hospital was negligent in its care and caused her to fall and sustain severe injuries. The trial court granted summary judgment to the hospital.

The taxpayer brought a malpractice suit against her attorneys in Washington state court. In her complaint, she alleged that her physical injuries were caused solely by the negligence of the hospital and that she would have prevailed in her claim against the hospital but for her attorneys' breach of the standard of care.

The taxpayer settled the lawsuit for $125,000, which she didn't report on her 2015 federal income tax return. The settlement agreement stated that she didn't sustain any physical injuries from the alleged negligence of her attorneys. The IRS audited the taxpayer and determined that the entire settlement amount was taxable.

Court Decision

The taxpayer argued that the settlement payment was received "on account of personal physical injuries or physical sickness." And, "but for" her attorneys' allegedly negligent representation, she would have received damages from the hospital that would be excludable under the tax law.

She further contended that her attorneys intended to compensate her for the physical injuries she allegedly sustained at the hospital. In addition, the taxpayer argued that the payment represented a nontaxable return of capital.

The Tax Court disagreed with these arguments. The court held that a taxpayer must show that there's a direct causal link between the damages and any personal injuries sustained. In the settlement agreement, the parties made it clear that the amount paid wasn't directly linked to the personal injuries suffered by the taxpayer. Instead, it compensated her only for legal malpractice.

The court wasn't convinced that the taxpayer experienced a "loss" at all, characterizing the amount she claimed she would have received from the underlying lawsuit as "highly speculative." It concluded that her settlement didn't restore her capital, rather it provided compensation for her lawyers' failings.

As a result, the court sided with the IRS, ruling that the $125,000 settlement was includable in the taxpayer's gross income.

Bottom Line

Many clients are happy to receive a sizable settlement award, until they're hit with a sizable tax bill — or a deficiency notice because they didn't realize that their settlement proceeds were subject to federal income tax. It's important to review the tax rules with your clients before they agree to a settlement amount. Your financial advisor can provide guidance on this issue.

To Tax or Not to Tax?

You aren't required to pay tax on settlement payments received as compensation for physical injury or physical sickness. 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.

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