Taxing Lessons Case Summaries

Case — Taxability of Legal Settlement

Thanks for sharing!
3 minute read

TL Case Summ


Are settlement proceeds received as a result of false imprisonment taxable?


Taxpayer Says: The settlement proceeds arose from a claim based on tort rights. In addition, physical restraint and detention constitute a physical injury. The proceeds qualify for exclusion and are not taxable.

Internal Revenue Service Says: The settlement was for nonphysical injuries, and should be included in income.


From Internal Revenue Code Section 61(a): Except as otherwise specifically provided, gross income includes “all income from whatever source derived.”

From Internal Revenue Code Section 104(a)(2): Excludes from gross income damages received on account of personal physical injury or physical sickness. In order to qualify for income exclusion under section 104(a)(2), taxpayers must satisfy a two-prong test: (1) The underlying cause of action giving rise to the settlement award must be based upon tort or tort type rights, and (2) the damages must be received on account of personal physical injuries or physical sickness.

From Black’s Law Dictionary 1526 (8th ed. 2004): The term “tort” has been defined broadly as “a civil wrong, other than breach of contract, for which a remedy may be obtained, usually in the form of damages” or “a breach of a duty that the law imposes on persons who stand in a  particular relation to one another.”


Generally, when you receive damages under a settlement agreement, the tax treatment depends on the nature of your claim. Settlement proceeds are treated as if they are the thing for which they are substituted. As an example, if your settlement represents a taxable item, such as lost wages, the proceeds are taxable. If your settlement represents a non-taxable item, such as a personal injury award, the proceeds are not taxable.

In this case, the taxpayer was arrested and detained because her bank mistakenly dishonored her check. The settlement proceeds arose from the resulting legal action. While the taxpayer admits she suffered no bodily harm, she says physical restraint and detention constitute a physical injury. She believes the proceeds are not taxable because they meet both prongs of the income exclusion test under Code section 104.

The IRS says the settlement resulted from a breach of fiduciary duty and negligence on the part of the bank, both of which are based on contract and therefore are not torts, and that the false arrest did not result in physical injury. The proceeds do not meet either statutory exclusion and are includible in income.


Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the


Download (PDF, 26KB)


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 and

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.


Other posts you might enjoy

Decisions — Taxing choices Image source: Free Picture © Semen Barkovskiy Dreamstime Stock Photos   How many options can you consider before you find yourself longing for simplicity? Whatever your answer, part of the desire for less complexity comes from not wanting to make the wrong choice. That's especially true ...
Decisions — Where’s your refund? Image source: By U.S. National Archives and Records Administration, Public domain, via Wikimedia Commons Where's your refund? Possibly helping to reduce the federal budget deficit, if you failed to file a return to get an overpayment back within the applicable time period. That's because the gov...
Case — Fun and games Image source: (public domain image) THE QUESTION Does an organization that offers a recreational activity to achieve a charitable purpose qualify as a charitable organization? THE DISPUTE Taxpayer Says: It operates for charitable purposes because it provides relief for the p...
Case — Carry On THE QUESTION Can an IRA deduction that is disallowed due to active participant status in an employer plan be carried forward and deducted in a future year? THE DISPUTE Taxpayer Says: The 2008 IRA contribution was an “excess contribution” and should be allowable as a deduction in 2010. Intern...
Sorry, wrong answer :(
Right answer!
For the IRS. Taxpayer received the settlement for claims based on tort or tort type rights, but physical restraint and physical detention are not physical injuries for purposes of Section 104(a)(2). The settlement proceeds are not excludable from income.