Allocating Damages to Avoid IRC 6662 Penalties

When a person recovers money for a tort injury committed by another person, an historic source of exclusion of that recovery from income tax is Section 104(a)(2) of the Internal Revenue Code.

The current version of this exclusion exempts from federal income tax:

“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.”

An exclusion exists as a matter of legislative grace and is typically construed narrowly when a taxpayer seeks to come within its scope. The burden of proof is on the taxpayer to meet all requirements imposed by the Code in order to qualify for the exclusion.

The Small Business Job Protection Act of 1996 amended IRC 104(a)(2). The major changes in the 1996 wording were the addition of the word “physical” plus a clarification that punitive damages are taxable. Payments to which the 1996 Act applies that are on account of non-physical injury or non-physical sickness also are now included in a recipient’s federal gross taxable income.

This rewording did not settle all issues surrounding what is taxable or not taxable. Issues have arisen on a range of topics, including:

    • what constitutes “damages;”
    • the treatment of derivative claims;
    • punitive damages in the context of physical injury or sickness claims;
    • claims for emotional distress;
    • mixed claims and allocations in settlement agreements;
    • disability-based discrimination claims;
    • sexual harassment and gender discrimination claims;
    • claims that originate with a physical act but are associated with no or dubious claims of physical injury or physical sickness;
    • and periodic payment obligations assumed by and payable from a new life insurance company following the insolvency of an original annuity provider.

The potential problems for recipients of settlements whose attorneys do not understand and properly plan and document these damage issues include IRC 6662. Section 6662(a) of the Internal Revenue Code imposes an accuracy-related penalty equal to 20 percent of the underpayment to which Section 6662 applies. An understatement is equal to the excess of: 1) the amount of tax required to be shown in the tax return over and 2) the amount of tax shown in the return. The penalty can be triggered in a number of different scenarios, including when a plaintiff understates the taxable portion of a settlement by more than $5,000.

Although IRC 6662 can arise in multiple factual circumstances, one of the most common applications in personal injury cases involves allocation between taxable and non-taxable damages. Note, however, the IRS is not bound by the allocation method parties to a settlement agreement decide to allocate portions of that settlement. The IRS may instead require submission of case pleadings and other documents to support a settlement allocation. Therefore, a sensible allocation in a settlement agreement between taxable and non-taxable portions of a claim can be extremely beneficial to a taxpayer.

When there is a mix of underlying claims for physical and non-physical injury or sickness, case law has established that the critical factor in assessing the tax exempt character of an allocation of the payments received when there is some amount of physical injury or physical sickness is the payor’s intent.

To exclude a settlement payment made in a lawsuit involving taxable and non-taxable damages, a plaintiff payee generally must show:

  1. the payor’s intent was to extinguish claims for physical personal injuries or physical sickness; and
  2. the amount of non-taxable damages paid for that purpose.

As practical guidance to minimize a potential IRC 6662 penalty, therefore to the extent reasonable and supportable by reference to claims made in a complaint, a settlement agreement should make express statements about what amounts are assigned to claims that are related to physical injury and physical sickness. Where physical personal injury or physical illness is not alleged in a complaint, there will might be no basis to claim exemption of recoveries.

Depending upon the facts of a particular case, however, a simple allocation between taxable and non-taxable damages in a settlement agreement may not prove adequate to avoid either a re-allocation by the IRS or an IRC 6662 underpayment penalty.

Jeremy Babener’s SSP Webinar

In his August 25, 2020 Society of Settlement Planners (SSP) webinar titled “The Perfect Storm: A Case Study of Personal Injury Tax Issues”, tax attorney Jeremy Babener recommended multiple tax strategies to increase the net value of a hypothetical case including reducing the risk of IRS issues.

One of those strategies involved first identifying all of the potential tax free “buckets” of damages that might be applicable to the particular case and then allocating damages to each bucket. In Jeremy’s hypothetical case, these tax-free damage categories included:

  1. bodily injury;
  2. harm to physical rights;
  3. physical sickness; and
  4. non-physical harms resulting from the physical injury including expenses to treat distress.

Jeremy emphasized it is essential for plaintiffs to allocate damages. Otherwise, the IRS can determine all damages are taxable. Also, an allocation must be reasonable and defensible because the IRS can dispute that any allocation was not made at arms-length with the defendant(s).

Jeremy confirmed the defendants’ intent is most important for determining damage allocation. He acknowledged that many defendants refuse to assist plaintiffs in making “tax allocation” a part of a settlement.

Jeremy’s proposed counter strategy: specifically identify in the settlement agreement the facts that specific damages were paid for specific physical personal injuries. “Plaintiffs don’t need for defendants to take tax positions,” Jeremy stated. “Plaintiffs just need for defendants to confirm why they are paying for alleged injuries. That is, unless you need to prevent them from issuing a 1099 to the plaintiff overstating the taxable portion of the settlement.

Jeremy added: plaintiffs must push defendants on the facts. Damage allocations are “fact dependent.” Jeremy cautioned there are a lot of grey areas. There is no way to say for certain in a specific case for what any allocated damages were actually intended.

For additional discussion about allocation of damages, check out Jeremy Babener’s members only SSP webinar and/or Chapter 2 of “Structured Settlements and Periodic Payment Judgments.” 

Portions of this article are excerpted with permission from “Structured Settlements and Periodic Payment Judgments” © 2020 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

TAX & LEGAL DISCLOSURE: Information contained herein is not intended to be case specific tax or legal advice nor is it intended or written to be used, and cannot be used, for the purpose of avoiding any tax or social security penalties. You should seek advice based on your particular circumstances from an independent tax or legal advisor if you have tax or legal related questions.