Taxes On Class Action Suit

[Rowe]

s About Taxes)/taxes on class action suit Advertisement Expert: Glenn D Schnabel - 6/20/2008 I received a check from a class action suit, and I was wondering if I had to pay taxes on it.  I never received a 1099 form and I had no out of pocket costs. The suit was due to some contaminated soil removal in a city park and I was effected by my property value.  The only note that I got was a message on the check stub, that stated this will be your only copy and no taxes were taken out.

[Sutcliff]

Tom,

Thank you for your question.

I answered this question from a previous taxpayers question concerning A Phen Phen settlement. Below is the research I found. According to the IRS web site:

Tax Treatment of Awards and Settlements

Awards and settlements can basically be divided into two distinct groups. One group includes claims arising from a physical injury and the other group includes those arising from a non-physical injury. The claims from each of the two major groups will usually fall into three categories:  1. Actual damages resulting from the physical or non-physical injury;  2. Emotional distress damages arising from the actual physical or non-physical injury; and  3. Punitive damages.

Physical Personal Injury or Sickness

Physical

IRC section 104(a)(2) provides for an exclusion from gross income for damages received(whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injury or sickness.

Section 7641 of the Omnibus Budget Reconciliation Act of 1989 amended IRC section 104(a)(2) by adding flush language: "Paragraph(2) shall not apply to any punitive damages in connection with a case not involving physical injury or physical sickness." This amendment applies to punitive damages received after July 10, 1989, in tax years ending after that date.

Nevertheless, some taxpayers have erroneously failed to report as income almost all types of awards/settlements under IRC section 104(a)(2) due to personal injury. The Service has consistently held that compensatory damages, including lost wages, received on account of a physical injury are excludable from gross income. Rev. Rul. 85-97, 1985-2 C.B. 50, amplifying Rev. Rul. 61-1, 1961-1 C.B. 14. See also Commissioner v. Schleier, 515 U.S. 323, 329-330(1995), in which the Supreme Court, employing a similar set of facts as the ruling, held that medical expenses not previously deducted, pain and suffering damages, and lost wages received by accident victim are excludable from income.

IRC section 104(a)(2) was amended in 1996. The amended section 104(a)(2) excludes from gross income damages received on account of personal physical injury or physical sickness only. However, the limitation to personal physical injuries or physical sickness contained in the 1996 amendment does not apply to any amount received under a written binding agree-ment, court decree, or mediation award in effect on(or issued on or before) September 13, 1995.

The House Committee Report for the 1996 changes(excerpts attached as Appendix D) states:

If an action has its origin in a physical injury or physical sickness, then all damages(other than punitive) that flow therefrom are treated as payments received on account of physical injury or physical sickness whether or not the recipient of the damages is the injured party. For example, damages(other than punitive) received by an individual on account of a claim for loss of consortium due to the physical injury or physical sickness of such individual's spouse are excludable from gross income.

Emotional

The exclusion from gross income under IRC section 104(a)(2) also applies to any compensatory damages received based on a claim of emotional distress or mental/emotional injury that is attributable to a physical injury or physical sickness. For more information on damages paid for emotional injuries stemming from physical injury/sickness, see discussion under "Physical" above. Emotional claims pertaining to non-physical personal injury/sickness" is covered later on in this guide.

Determining the amounts allocable to mental/emotional injuries may not always be easy. The facts and circumstances of each award/settlement must be examined, and amounts which can be reasonably allocated to genuine mental injury should be allowed. The allocation is necessary when economic damages, for example, back pay, or punitive damages is requested as relief in a case involving a physical or non-physical personal injury.   * Points to consider:         o Did payor intend to compensate the recipient for his or her claim of mental distress? If so, how much? But see Hemelt v. United States, 122 F.3d at 208("the characterization of a settlement cannot depend entirely on the intent of the parties") citing Dotson v. United States, 87 F.3d at 687, and Mayberry v. United States, 151 F.3d at 859.         o What did the payor think? That is, whether he/she/it could win or lose(elements of the claim).         o Were there medical bills for mental disturbances?         o Was there psychological treatment or counseling?         o Were there lost workdays?         o Is there documentation for medications, antidepressants, etc?         o Did this situation cause taxpayer to be absent from work?         o Was there sick leave used?         o Did taxpayer continue to care for his/her family?         o Did taxpayer continue with daily affairs?     For the allocation, start with the total payment less the actual, obvious losses, then allocate between compensatory and punitive.     Punitive Damages   * Punitive damages are not excludable from gross income under IRC section 104(a)(2).     The position of the IRS on the taxation of punitive damages has not been constant. In Rev. Rul. 58-418, 1958-2 C.B. 18, the Service published its position that punitive damages do not qualify for exclusion under IRC section 104(a)(2). See Thomson v. Commissioner, 406 F.2d 1006, 69-1 U.S.T.C. 9199(9th Cir. 1969). In Rev. Rul. 75-45, 1975-1 C.B. 47, the Service changed its position and concluded that punitive damages were excludable. See Roemer v. Commissioner, 716 F.2d 693, 83-2 U.S.T.C. 9600(9th Cir. 1983), following the Service reluctantly on this issue. Addressing the Alabama wrongful death statute, the Service ruled that punitive damages were again taxable. Rev. Rul. 84-108, 1984-2 C.B. 32. Accordingly, Rev. Rul. 75-45 was revoked. See Burford v. United States, 642 F. Supp. 635(N.D. Ala. 1986), disagreeing with Rev. Rul. 84-108. Prior to 1989, the courts, however, often did not agree. After 1989, some commentators believed that the courts would interpret the additional verbiage to IRC section 104(a)(2) to exclude punitive damages paid relative to a physical injury or physical sickness.     However, in the Tenth Circuit's decision in O'Gilvie v. United States, 95-2 U.S.T.C., 50,508, 66 F.3d 1550, the court ruled that "non-compensatory punitive damages are not received on account of personal injuries, and thus are not excludable from gross income under IRC section 104(a)(2)."     In O'Gilvie, the Tenth Circuit applied the Supreme Court's ruling in the case of Commissioner v. Schleier,(1995 S.Ct.), 75 AFTR 2d 95-2675; 115 S.Ct. 2159, 515 U.S. 323, involving employment discrimination, to a case involving wrongful death. Schleier held that there are two independent tests which must be met for the IRC section 104(a)(2) exclusion to apply:(1) The underlying cause of action giving rise to the recovery must be based on tort or tort-type rights; and(2) the damages must "have been received on account of personal injuries or sickness."     Prior to this time, some of the courts had relied on only the first requirement of a tort-type underlying claim in holding that the damages were excludable. See, for example, Hill v. United States, 733 F. Supp. 88, 1990-1 U.S.T.C. 50,170(D. Kan. 1990)(damages for tort of misrepresentation excludable from gross income).     The Supreme Court upheld the Tenth Circuit's decision. O'Gilvie 519 U.S. 79, 117 S. Ct. 452; 96-2 U.S.T.C. 50,664; 78 AFTR 2d 7454(1996). With this decision, the courts finally have clear guidance, which coincides with the Service's position on the taxation of punitive damages prior to the 1989 amendment to IRC section 104(a)(2).     With the enactment of Public Law 104-188, Section 1605(d), Congress made it clear in IRC section 104(a)(2) that punitive damages are taxable, regardless of the nature of the underlying claim.     However, the courts have not decided a case involving punitive damages subject to the 1989 amendment to IRC section 104(a)(2). In dictum, the Supreme Court indicated that Congress amended IRC section 104(a)(2) in 1989 to allow the exclusion of punitive damages only in cases involving physical injury or physical sickness. United States v. Burke, 504 U.S. at 236, n.6. Faced with the taxation of punitive damages prior to the 1989 amendment and the specter of addressing the 1989 amendment in a subsequent case, the Supreme Court, retreating from the statement in Burke, rejected the taxpayer's argument that was based on this dictum. O'Gilvie, 519 U.S. at 89-90. The Court indicated that Congress' focus in 1989 was on what to do about non-physical personal injuries rather than on punitive damages under prior law. The Court's statement lays to rest the negative inference and provides support for the conclusion that, in enacting the 1989 amendment, Congress did not intend to create an exclusion for punitive damages received in connection with a physical injury or physical sickness. See, also, Miller v. Commissioner, 914 F.2d 586, 588, n. 4(4th Cir. 1990)(Congress has amended IRC section 104(a)(2) so that it now explicitly does not exclude from gross income "punitive damages received in connection with a case not involving physical injury or physical sickness.")

Wrongful Death

Hope this information is useful.