Lawsuit Awards Could Generate Taxable Income

If you are a party to a lawsuit and you win, congratulations! But keep in mind that sometimes the financial award you receive may be taxable income.

In fact, most awards are taxable income. But like everything related to the tax code, there are exceptions. For instance, when the award stems from a physical or emotional distress, the compensation is not taxable. Emotional distress must stem from a physical injury or sickness.

So let’s say you got food poisoning on that Caribbean cruise you otherwise enjoyed so much. In suing the cruise ship company, you are awarded $100,000 for medical bills and $50,000 for emotional distress (after all, you thought you were going to die!). The entire award of $150,000 would be excludable from your taxable income.

That’s an easy one. But in reality, nothing is so cut and dried. In fact, it can get rather complicated.

There was a case recently that the IRS ruled upon in a Private Letter Ruling. Victims of a large building fire were allowed to exclude damages from their gross income when they “suffered a scrape, bruise, or other visible physical injury or suffered smoke inhalation.”  Some of the damages received were for emotional distress by the fire in general as well as emotional distress because they witnessed relatives die in the fire. This begs the question: Do emotional distress damages have to be allocated between those caused by a physical injury (scrapes included) and those attributable to the events that did not cause a physical injury, e.g. witnessing others perish? Commentators believe the Private Letter Ruling supports the latter view.

But now let’s say that you suffered emotional distress because of discrimination in the workplace or any other event where physical injury or illness was not a factor. The award for emotional distress in this situation is considered taxable income.

But here’s a situation similar to the fire incident, vis a vis the “bruise ruling,” that had a tenable outcome. A woman was sexually harassed in the workplace by her employer. The harassment started out as verbal, but then one day he physically attacked her. She sued and received damages, including damages for emotional distress. The IRS ruled that the award was all taxable income.

The agency ruled “damages for events up to the time of the attack were not excludable from gross income because they were not due to a physical injury which requires ‘observable bodily harm.’” It defines observable bodily harm as bruises, cuts, swelling and bleeding.  Apparently, she had no such symptoms. Therefore, she was required to pay taxes on the income. The IRS ruled that in this case versus the Fire case there was no such bright line.

Then there’s the guy who had a bee farm. Someone burned it down on purpose and he sued and won damages in the amount of $577,000. He claimed that he received injuries to his “nervous system and person,” including a rash from the ash. And that he was inflicted with great mental, physical, emotional, and nervous pain and suffering. He also stated that he developed breathing problems from inhaling the dust and ash caused by the fire. However, he wasn’t present during the fire and didn’t go to the doctor.

The IRS concluded that the damages were essentially for property loss. The fire destroyed two homes, 40 vehicles, 600 bee hives and bee farming equipment and supplies. There may have possibly been a different outcome had the victim sought medical help to prove that he was physically harmed.