Part 3 of this series focuses on the payment of damages for sexual abuse. As we all know, the problem of sexual abuse has become an epidemic over the last three decades. It seems to be everywhere. In many instances, the litigation occurs after the alleged sexual abuse.
As a practical matter, many states have altered their statute of limitations for sexual abuse allegations making it easier for these cases to be brought before courts. Nevertheless, the time difference between the actual physical and emotional injury and actual litigation creates some confusion as to the tax treatment of damages.
This article is designed to outline the tax treatment for plaintiffs.
A Review of IRC Sec 104(a)(2)
The Small Business Protection Act of 1996 added IRC Sec 104(a)(2) to the Internal Revenue Code changing the landscape for the taxation of settlements and damages. The new section made a small but significant change by limiting tax-free treatment as a result of personal “physical” injuries and “physical” sickness.
IRC Sec 104(a)(2) excludes from gross income 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
Emotional distress is generally not considered a physical injury or physical sickness. However, damages for emotional distress attributable to a physical injury or physical sickness are excluded from income under section 104(a)(2).
Internal Revenue Bulletin 2012-12 added final regulations which had been pending since 1996 and substantial amounts of litigation regarding the “on account of physical injury and physical sickness” test of IRC Sec 104(a)(2).
The final regulations adopt the provision under the proposed regulations that delete the requirement that to qualify for exclusion from gross income, damages received from a legal suit, action, or settlement agreement must be based upon “tort or tort type rights
Taxation of Damages of Sexual Abuse
After the addition of IRC Sec 104(a)(2) the IRS position on damages has been “Show me the bruises and broken bones”, .i.e. observable bodily harm, in order to establish damages on account of personal physical sickness and injury. Recently, the IRS has been more conciliatory in the area of sexual abuse settlements.
The IRS National Taxpayer Advocate Nina Olsen in a report to Congress in 2010 recommended that non-physical injuries such as emotional distress, mental anguish, and pain and suffering not be taxed under IRC Sec 104(a)(2). The report presented scientific data linking the physical connection to many mental and emotional illnesses such as depression. Ms. Olsen also stated that the Government’s tax position conflicted with public policy principally the non-discrimination requirement in the Mental Health Parity and Addiction Equity Act of 2008.
In an IRS Chief Counsel Advice Memoranda (CCA 200809001), the Office of Chief Counsel cited a sexual abuse fact pattern. In the fact pattern, the plaintiff suffered physical injury as a result of sexual abuse as a child. A significant amount of time had passed since the events making it difficult to establish the extent of the physical injuries suffered as a result of the abuse. Nevertheless, the IRS conceded that it was reasonable to presume that all damages were the result of physical injuries and that the emotional distress suffered was attributable to the physical injuries suffered years before.
Interestingly, the author of CCA 200809001 was also the author of PLR200041002 that concluded that any damages received for unwanted physical contact without any readily observable bodily contact were not received on account of personal physical sickness or injury. These more recent pronouncements seem to indicate a new trend in the IRS position on sexual abuse.
These indications expand the rationale of an older U.S. Supreme Court case, Commissioner v. Schleir, 515 U.S. 323, Doc 95-5972, 95 TNT 116-8 (1995), . The ruling created a two-pronged test. The ruling splits the factual analysis into two time frames – (1) Before the Occurrence of the First Pain Incident and (2) On Occurrence or shortly after the first Pain Incident.
In Schleir, damages received before the occurrence of the First Pain Incident are not received on account of a personal physical injury or sickness and are not exempt from taxation under IRC Sec 104(a)(2). Damages as a result of injury on occurrence of or after the First Pain Incident for pain and suffering, emotional distress and reimbursement of medical expenses are properly allocable to personal physical injury and receive tax-free treatment under IRC Sec 104(a)(2).
On one hand it is easy to understand the IRS’ litigation position resulting from all of the prior tax abuse which preceded the adoption of IRC Sec 104(a)(2) as many plaintiffs tried to categorize any type of settlement and damages payments as “emotional distress.” The increasing body of scientific research linking the connection between the physiological component of many mental and emotional illness has established a clear basis for treating sexual abuse payments as payments for personal physical injury. From a slightly cynical perspective, the IRS would suffer considerable public relations embarrassment failing to acknowledge the physical component of the emotional distress and pain and suffering of the typical sexual abuse victim. It would seem odd that a Church would receive tax-exempt tax status but the victims of any sexual abuse perpetrated by church employees would have to pay taxes on any settlement awards or damages.
There are several learning points to consider. First, the settlement agreement or release should indicate that payments are “personal physical injury and sickness or emotional distress arising out of the physical injuries.”. Second, the sexual assault or abuse should be referenced in the settlement agreement if possible. Third, the defendant should agree in the settlement that Form 1099 will not be filed with the IRS. Fourth, the medical records as well as any statements from the attending physicians and psychiatrists should be reviewed so that it can help to support the argument of personal physical injury as the basis for the plaintiff’s emotional distress.
Getting the tax treatment of a settlement wrong, can add insult to injury. The plaintiff in a sexual abuse case has likely suffered for some time. Litigation in this area is also very much a “contact sport” and places the victim in the line of fire once again. Litigation also takes time to resolve.
In the current tax environment, a mistake in the tax aspects of the case can cause the plaintiff depending upon the state of residence a “haircut” of 35-55 percent of the settlement award depending upon the size of the settlement.
Justice and the pursuit of justice is a noble pursuit, but justice on an after-tax basis is something less!