Midnight surprise - personal injury alert.

In the Small Business Job Protection Act of 1996, Congress severely limited the income exclusion of damages received on account of personal injury. The law was passed by Congress with several restrictions that were in the House Bill, but not die Senate Bill. The exclusion generally applies to amounts received after Sept. 13, 1995.

All Punitive Damages Taxable

First, whatever contrary argument there was prior to this bill, all punitive damages are taxable, except in a wrongful death action when only punitive damages may be awarded. It does not matter the type of case, i.e., whether it relates to personal injury, or whether there are physical injuries or nonphysical injuries. (See O'Gilvie, 66 F3d 1550 (10th Cir. 1995), on the taxability of punitive damages in cases of personal physical injury. When the Supreme Court decides this case, its decision will not apply to punitive damages received after the date of enactment of the law.)

Damages Excluded From Income

Only for Compensation of

Personal Physical Injury

Compensatory damages are exempt from tax only when awarded for (1) personal injury or (2) physical injury or sickness. These are two separate and distinct requirements.

The first requirement - for personal injury - is murkier than ever. Under prior law, the courts and the IRS evaluated whether the damages were personal, as compared to business or professional. There was an additional requirement that the injury be from a tort or tort-like action. Presumably, these two requirements are still in place.

The second requirement is not clearly defined either in the law or the committee report. However, following the Supreme Courts decision in Schleier, 115 Sup. Ct. 2159 (1995), physical injuries are likely to be defined as injuries of the body or mind. Physical injuries must be distinguished from injury with no harm to the body, as in cases of defamation or discrimination or a wrongful discharge claim with an accompanying claim for defamation. Therefore, one must separate injuries to the person/body, as compared to economic interests.

Damages Flowing From Physical

Injury or Sickness

The more interesting issues relate to claims based on a personal physical injury along with pain and suffering, as well as other claims for such items as discrimination and loss of wages (physical and nonphysical injuries). The committee report specifically provides for the exclusion of all damages that flow from a personal physical injury, whether or not the recipient is the injured party.

First, Congress specifically limited the income exclusion for an amount of damages solely for emotional distress. The statute limits the exclusion to the amount of medical expenses. Therefore, one will not be able to avoid income inclusion by allocating amounts of damages solely to emotional distress, when this is the only "physical injury." However, the committee report indicates if there is a physical injury, the related damages for emotional distress are exempted. Therefore, the limitation on emotional distress damages applies only when there is distress accompanied by nonphysical personal injuries.

There will be cases (such as auto accidents) in which damages will be given for physical injury as well as loss of wages (an economic injury). Based on the committee report, the courts and the Service should probably allow for the exclusion of all these damages. In looking at the origin of the claim type of injury, and the damages that flow therefrom, there is no specific guidance as to when, and to what extent, damages flow from a personal physical injury or physical sickness.

Allocating Damages

As a result of this legislation, when there are multiple theories for recovery, it is wise to classify claims as claims for personal physical injury, if possible, in order to have income excludible. If there are multiple claims, damages will have to be allocated among the claims. Allocations of proceeds in a settlement agreement for a personal injury will generally be accepted by the IRS if the parties engaged in bona fide, arm's-length, adversarial negotiations. But parties will no longer be able to exclude income by allocating damages for compensatory damages between personal physical injuries and personal nonphysical injuries, in order to avoid inclusion of income due to possible punitive damages. (Under prior law, all compensatory damages from personal injury were generally excludible from income.)

Compensatory Versus Punitive

Damages

Another area that is unclear is the allocation between compensatory damages and punitive damages, after the congressional changes and Schleier. In Schleier, the Supreme Court evaluated the damages that could be awarded under an Age Discrimination in Employment Act (ADEA) claim. Under the ADEA, the party was entitled to liquidated damages, and according to the court, "Congress intended the damages to be punitive," particularly since such damages are only available if an employer "knew or showed reckless disregard for the matter of whether its conduct was prohibited.... If liquidated damages were designed to compensate ADEA victims, we [the Court] see no reason why the employer's knowledge of the unlawfulness of his conduct should be a determinative factor in the award of liquidated damages."

The logical conclusion to this argument is that no damages can be excluded when there is intentional misconduct and/or the damages relate to the intentional misconduct.

Presumably, the Supreme Court's holding applies only in the type of case in which there can be no proper allocation of damages between compensatory and punitive damages, and all of the damages must be allocated to punitive damages.

With personal injuries based on state tort claims, it would be wise to delineate clearly the portion of damages received for compensation on account of personal physical injury or sickness.