Prejudgment interest on personal injury suit is taxable.

When a gas leak caused an explosion in their home, the Brabsons were injured and incurred property damage. They filed a lawsuit seeking compensation. After a jury trial, they were awarded damages plus interest covering the time they had to wait for the award. Colorado state law characterized the prejudgment interest as compensation for personal injuries.

The Brabsons did not report the interest as income. They claimed it was excludable under IRC section 104(a)(2), which excludes "any damages received...on account of personal injuries or sickness." The IRS claimed the interest was taxable.

The district court found the damages were excludable, based on the state law's characterization of the interest as compensation for personal injury. The IRS appealed.

Result: For the IRS. The interest is taxable. Under the Supreme Court decision in Schleier, a payment is excludable under section 104(a) only if(1) it was made based on "tort or tort-type rights," and (2) it is "on account of" personal injuries. The second part requires a direct link between the injury and the payment. In this case, the direct link does not exist, since the interest is primarily intended to compensate the plaintiff for the time value of the money. Thus, the interest is not paid "on account of" a personal injury.

* Brabson (10th Cir., 1996).

Note: The Tax Court has consistently held that prejudgment interest is taxable, regardless of how it is characterized under state law. (See Kovacs, 100 TC 124 (1993).) The Sixth Circuit Court of Appeals affirmed Kovacs in an unreported decision. This is the first published appeals-level decision governing statutory prejudgment interest.

Edited by Anne Wagenbrenner, JD, LLM, editor, AICPA client newsletters.