Discussion:Attorney Fees in Emotional Distress Settlement

Q: My client is receiving a structured settlement for emotional distress. She is only receiving a percentage and her attorneys are receiving the rest. Is she required to include their portion in her income? Also, is she only required to report the amount received in the current year?

Thanks for any help!''

A: Unless the emotional distress was caused by physical injury, the recovery will be included in her gross income (except to the extent of her costs for medical treatment of this emotional distress). The attorney fees received by her attorneys will also be included in her gross income. She should be able to claim a deduction for any amounts actually paid to her attorneys.

I'm having some trouble reconciling your post "Unless the emotional distress was caused by physical injury, the recovery will be included in her gross income (except to the extent of her costs for medical treatment of this emotional distress)." with the statutory language in §104(a)(5). I'm of the impression e.d. is defined to not be excludable except as you note to the extent there would be medical expenses attributable to the e.d. I've posted a small snip.

[begin] For purposes of paragraph (2) , emotional distress shall not be treated as a physical injury or physical sickness. The preceding sentence shall not apply to an amount of damages not in excess of the amount paid for medical care (described in subparagraph (A) or (B) of section 213(d)(1) ) attributable to emotional distress. [end]

Paragraph 2 is the exclusion for physical injury or physical sickness. The Tax Court appears to agree with this statutory language and routinely hold damages for e.d. to be taxable. Would appreciate your thoughts.

Note: This is a big day for me...I answered a Riley2 question!

The problem with that regulation is that it was written well before the Small Business Job Protection Act in 1996. In SBJPA Congress added a modifier to the IRC in §104 - so it now reads personal PHYSICAL injury. SBJPA also added the two sentences on e.d.

"...gross income does not include - 2) 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"

It sounds like this would mean that the emotional damages stemming from the physical injury/sickness would be excluded from gross income since they were "on account of personal physical injury."

This could also mean that lost wages resulting from the personal physcal injury, would be excluded from gross income as well. Not to sure about that though. Depends on the definition of "compensatory damages," I guess.

This is my feeling too, partly based on the fact that I have had no telephone calls from clients involved in such settlements, calling me to suggest a structure for the settlement. Naturally if the part for 'pain and suffering' is going to be taxed, personal injury lawyers will build that tax into the equation. I also base my feeling on the fact that lawyers will tell you to consult your tax advisor in any case where they are unsure. Admittedly this is not a scientific poll. I'd also note that 1099s for such settlements have been rare.

The Committee reports go on to state that the exclusion is not limited to the injured person’s damages. For example, damages for loss of consortium suffered by the spouse of the injured person would also be excludible.

Albert Einstein may have been correct that “[t]he hardest thing in the world to understand is the income tax,” The Macmillan Book of Business and Economic Quotations 195 (Michael Jackman ed., 1984), but it is not hard to understand that not all receipts of money are income. Murphy’s compensatory award in particular was not received “in lieu of” something normally taxed as income; nor is it within the meaning of the term “incomes” as used in the Sixteenth Amendment. Therefore, insofar as § 104(a)(2) permits the taxation of compensation for a personal injury, which compensation is unrelated to lost wages or earnings, that provision is unconstitutional. Accordingly, we remand this case to the district court to enter an order and judgment instructing the Government to refund the taxes Murphy paid on her award plus applicable interest. So ordered.

Funny but how none of us, including Riley, could keep ourselves from expanding the subject. Riley's original questioners said nothing about physical injury.

Thanks for the heads-up. I looked at the JCT report on the mark-up of the bill and your interpretaion is indeed correct. So much for the "clear language of the statute" when it comes to §104.

this site might help: [1]

My client received a JUDGMENT, not a settlement, for emotional distress. NOT caused by physical injury. The judgment by the jurors called for $100,000 emotional distress, $16,000 back wages, and $2,000 interest. The attorneys fees for this were about $2300. The total judgment check was delivered to attorneys and attorneys took their fees and delivered rest to client.

$100,000 is fully taxable (NO FICA). No tax document was issued for these monies. $16,000 is taxable as back wages and I have reported on Form 4137 (No Corrected W-2 issued and understand one will not be issued). Interest is taxable but not placed on Schedule B (No 1099 issued). Where would you report the $100,000????? 1040 line 21? Also, based on the history, would I need to report the $2300 in attorneys fees in received amount and then take a SCH A deduction??? Also, client did not pay full tax owed at the due date - do you think we can try to get penalties and interest avoided due to researching tax law and issue? (I know a shot in the dark).