Is a disability lump sum settlement payment excludable from gross income?
Taxpayer Says: The lump sum settlement from a disability claim is not taxable because the payment was from a lawsuit resulting from an on-the-job injury.
Internal Revenue Service Says: The settlement does not qualify for an exclusion to the general rule and is taxable.
From Internal Revenue Code Section 61(a): Defines gross income as “all income from whatever source derived,” unless otherwise provided.
From Internal Revenue Code Section 105(a): Provides that amounts received by an employee through accident or health insurance for personal injuries or sickness shall be included in gross income to the extent such amounts (1) are attributable to employer contributions that were not includable in the employee’s gross income, or (2) were paid by the employer.
From Internal Revenue Code Section 105(c): Provides an exception to the general rule in section 105(a). Section 105(c): Payments Unrelated to Absence From Work.– Gross income does not include amounts referred to in subsection (a) to the extent such amounts– (1) constitute payment for the permanent loss or loss of use of a member or function of the body, or the permanent disfigurement, of the taxpayer, his spouse, or a dependent (as defined in section 152, determined without regard to subsections (b)(1), (b)(2), and (d)(1)(B) thereof), and (2) are computed with reference to the nature of the injury without regard to the period the employee is absent from work.
THE CAUSE OF THE DISPUTE
In general, when your employer pays the premiums for disability insurance, any benefits you receive under the plan will be taxable income in the year you receive them. The rule applies to lump sum payments as well as monthly amounts.
Under an exception to the general rule, disability benefits may be excluded from your income when the amount you receive is calculated based on the nature and severity of your injury, and not on the amount of time you’re away from your job.
In this case, the taxpayer’s employer paid the premiums on a group disability policy. Under the policy, disabled employees would receive a monthly benefit based on the employee’s salary regardless of the injury.
After hurting her back, the taxpayer applied for benefits under the policy, but was denied. She sued the insurance company, and eventually received a lump sum settlement of $333,647. The settlement was based on the amount of the monthly benefit payable under the policy and the date her benefits were terminated. The taxpayer did not report the payment on her 2005 income tax return because it was related to her injury and she believed it was therefore not taxable.
The IRS says the payment is taxable because it was based on the amount of time the taxpayer was absent from work, and the exception does not apply.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
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