Tax Issues: Damages, Recission and Debt Cancellation as Client Income

First Published in
The Consumer Advocate

Many clients and some lawyers assume that damages received in a lawsuit are not taxable. As far as the tax consequences of rescission and debt cancellation are concerned, these questions have been relegated to the dark corners of the legal world where some say only tax lawyers dare tread. The purpose of this article is to take some (but not all) of the mystery out of these subjects.

The starting point is § 61 of the Internal Revenue Code1 which provides that gross income means all income from whatever source derived except amounts specifically excluded. Section 104(a)(2) is the portion of the law which provides the basic exclusion for some personal injury awards. It states that gross income does not include "the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness." Taxpayers must meet two independent requirements before they can exclude a recovery under § 104(a)(2). First, the taxpayer must demonstrate that the underlying cause of action giving rise to the recovery is "based upon tort or tort-type rights"; and second, the taxpayer must show that the damages were received "on account of personal injuries or sickness." See Comm'r v. Schleier, 515 U.S. 323 (1995). State law controls whether there is a tort-type injury. See, e.g., Brabson v. United States, 73 F.3d 1040, 1044 (10th Cir. 1996).

The issue in Schleier was the taxability of a taxpayer’s recovery of back wages under the Age Discrimination in Employment Act of 1967. The Supreme Court held that the recovery did not fall wi thin the § 104(a)(2) exclusion of damages received on account of personal injury or physical sickness. The taxpayer’s employer fired him when he reached age 60, making age, not personal injury or physical sickness, the proximate cause of his lost income. Although the taxpayer’s unlawful termination may have caused some psychological or “personal” injury, no part of his recovery of back wages was attributable to that injury. Nor could the liquidated damages award be excluded from gross income within the meaning of the applicable regulation to § 104(a)(2) because it was not received through prosecution or settlement of an action based upon tort or tort-type rights, and was not received on account of personal injuries or sickness. Schleier, 515 U.S. at 330.

The requirement that the damages be on account of “personal physical injuries or physical sickness” was added in 1996 generally for amounts received after August 20, 1996. P.L. 104-188, § 1605(c) (the “1996 Act”). If an action has its origin in a physical injury or physical sickness, then all damages (other than punitive damages) that flow therefrom are treated as damages received on account of personal physical injuries or physical sickness whether or not the recipient of the damages is the injured party. “For example, damages (other than punitive damages) received by an individual on a claim of loss of consortium due to the physical injury or physical sickness of that individual’s spouse are excludable from gross income.” H.R. Conf. Rep. No. 104-737, at 301 (1996), reprinted in 1996 U.S.C.C.A.N. 1474, 1589. If the tortious act causes physical injuries, which in turn cause other damages such as lost wages or pain and suffering, then all of the damages are “on account of” physical injury. See Banaitis v. Comm’r , 340 F. 3d 1074 (9th Cir. 2003).

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