The question recently came up, again, whether wage loss damages flowing from a personal physical injury were taxable. Any damages flowing from a personal physical injury are excluded under 104(a) of the IRC. The only elements of damages that are taxable in a personal injury action are punitives (or post judgment interest). Wage loss flowing from a personal physical injury is tax free. Personal injury damages are making you whole again and thus are exempt from being taxed under 104(a). The exclusion in 104(a) covers settlement payments received in physical injury lawsuits even though a portion of the recovery is for lost wages (income that if otherwise received would have been taxable). Revenue Ruling 85-97 confirms this fact.
The "Amos" case has confused some personal injury lawyers about the tax treatment of damages in a personal injury case. In the now infamous "Amos" decision, the tax court held that a portion of the settlement was taxable because it was for confidentiality and not physical injuries. The Amos case involved Dennis Rodman. Dennis Rodman, upon falling out of bounds during an NBA game, kicked Amos, a photographer in the groin. Amos filed suit, and the dispute settled for $200,000. The settlement agreement contained a confidentiality clause. Amos claimed all of the $200,000 was excluded from income tax as compensation for personal physical injury under IRC Section 104(a)(2). The IRS audited Amos' tax return and declared the $200,000 to be taxable compensation because they determined that the payment was motivated by a desire for confidentiality.
The tax court noted that the taxpayer has the burden of proving that damages are on account of personal physical injuries or sickness, under IRC Sec. 104(a) (2), citing Commissioner v Schleir, 515 U.S. 323, 328 (1995) and United States v. Burke, 504 U.S. 229, 248 (1992). "The nature of the claim forming the basis for the settlement controls whether such damages are excludable under IRC Sec. 104 (a)(2)." Burke, supra, 504 U.S. at 237. "The intent of the payor is critical" and "the character of the settlement payment hinges ultimately on the dominant reason of the payor in making the payment" Knuckles v. Commissioner, 349 F.2d 610, 613 (10th Cir. 1995). Thus, the tax court held that 60% of the damages were compensation for Amos' physical injuries, and 40% was payment for confidentiality. Thus, 40% of the damages were taxable. The cite to the Amos opinion is: Amos v. Commissioner, T.C. Memo 2003-329 (December 1, 2003).
The lesson is that it is important to pay attention to how damages are allocated in a settlement agreement. If there are questions about taxation of damages issues and/or monies allocated to a confidentiality agreement, a tax attorney should be consulted.