IRS manual counsels attorneys on verdict and settlement taxes.

The IRS got the message from the media: Too many taxpayers were declaring their lawsuit proceeds nontaxable.

During a project in Alabama, the IRS found that "analyses of newspaper articles revealed that numerous lawsuits were being resolved ... for substantial amounts," according to a new guide for auditors. A subsequent project revealed that "the vast majority of these lawsuit verdicts and settlements were escaping taxation."

The IRS has a program that trains auditors by market segments, focusing, for example, on particular industries, professions, or issues. Each program includes a guide that contains audit examination techniques, common and unique industry issues, business practices, industry terminology, and other information.

After the IRS identified the lawsuit market segment, it released in January the Market Segment Specialization Program Audit Technique Guide for Lawsuit Awards and Settlements. (The guide is available online at http:/www.irs.gov/prod/bus_info/ mssp/index.html; click on "Lawsuit Awards and Settlements.")

Because a business entity cannot suffer a personal injury according to the Internal Revenue Code, the guide applies only to individual recoveries. It is designed to show auditors how to recognize taxable verdicts and settlements, but it can be a valuable resource for attorneys seeking to educate their clients about potential taxes on recoveries.

"This guide will provide information on how to identify tax returns with lawsuit payment issues, suggestions on conducting the examination, detail of issues, explanations of applicable terminology, synopses of several related court cases, and exhibits of pertinent forms," according to the guide's introduction.

Section 104(a)(2) of the tax code provides that, except for punitive damages, amounts that a plaintiff receives for a physical injury are excludable from his or her gross income. The IRS has held that punitive damages are not received for personal injuries and therefore cannot be excluded from gross income. In 1996, Congress amended the section so that punitive damages are not excludable from income, whether they are related to physical or nonphysical injuries. Congress also limited the amounts excludable for emotional distress to out-of-pocket medical costs in cases of nonphysical injuries.

The 10-chapter guide covers topics including taxability of lawsuit proceeds and payments; sources of information (including newspaper articles, courthouse research, computer data, settlement payers, state insurance departments, and state supreme court libraries); and Form 1099 reporting requirements. It also includes a synopsis of litigated cases.

In the case section, the guide cites "the clear guidance of Burke and Schleier"--respectively, a sex discrimination case that outlined the two-part test for excluding damages under [sections] 104(a)(2) and an age discrimination case that discussed both physical and nonphysical tort injuries. (United States v. Burke, 504 U.S. 229 (1992) (finding that back pay received in settlement of Title VII claims was not excludable); Commissioner v. Schleier, 515 U.S. 323 (1995) (finding that payments received for age discrimination are taxable).)

These U.S. Supreme Court cases "contain our present authority for these types of cases," according to the guide, but it notes a number of other cases--including wrongful death, age and sex discrimination, employment, and insurance cases--that provide good discussion on defining torts and personal injuries.