Taxing Lessons Case Summaries

Case — Taxability of Legal Settlement

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THE QUESTION

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

THE DISPUTE

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.

THE LAW

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.”

THE CAUSE OF THE DISPUTE

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.

WHAT WOULD YOU DECIDE?

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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.

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Sorry, wrong answer :(
✓Right answer! 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.
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