The Internal Revenue Service put forth final regulations, effective January 23, 2012, addressing taxpayers receiving money damages arising from personal physical injuries or physical sickness and also taxpayers paying these damages. The changes implemented have been put in force through Treasury Decision 9573 revising IRS Reg. §1.104-1(c) regarding the income exclusion under IRC §104(a)(2). The revised regulation removed the tort type injury test for determining whether damages could be excluded from taxable income and also clarified the application of emotional damages.

The revised regulations deleted the requirement that money damages received from a legal suit, action, or settlement agreement would only be excluded from gross income if based upon a tort or tort type rights. Originally, the tort-type injury test was put forth in attempt to distinguish money damages received from personal injury as opposed to money damages received based upon another cause of action such as breach of contract.

Subsequently, through specific legislative and judicial developments, there is no longer a need to base the §104(a)(2) exclusion on tort cause of action and remedy concepts. Discussed in the preamble of the final regulations, the IRS cites both Commissioner v. Schleier, 515 U.S. 323 (1995) and the revisions adopted by Congress in 1996 as justification for removing the tort test. As a result, the new regulations now provide that the “exclusion may apply to damages recovered for a personal physical injury or physical sickness under a statute, even if that statute does not provide for a broad range of remedies. The injury need not be defined as a tort under state or common law.”

Next, Reg. §1.104-1(c)(1) clarified the circumstances under which money damages for emotional distress will be excluded from income. The revised regulations indicate that emotional distress, standing alone, is not considered a physical injury or physical sickness. However, money damages for emotional distress attributed to a physical injury or physical sickness will be excluded from income. For example, if a personal injury settlement resulted in a specific amount designated for the physical injuries and also an amount designated for the emotional distress caused by that same incident, all amounts would be excluded from income. On the other hand, if the suit was based on emotional distress only, and there was no physical injury or sickness, any award of damages would not qualify for the exclusion and would be taxable.

There is one exception noted that would allow for the exclusion of money damages related to emotional distress unrelated to any physical injuries. IRC §104(a)(2) does provide for the exclusion of money damages related to emotional distress to the extent such damages are not in excess of amounts paid for medical care related to such emotional distress.

The regulations define the term damages as “an amount received (other than workers’ compensation) through prosecution of a legal suit or action, or through a settlement agreement entered into in lieu of prosecution.”

For further discussion and explanation of the revised regulations relating to compensation for injuries or sickness, click here.