IRS Issues New Rules For Tax-Free Legal Settlements

(Forbes) Which personal injury recoveries are tax-free? For almost 80 years, Section 104 of the tax code has made many injury recoveries tax-free, whether you settle or go to court. Up until 1996, just about anything qualified, including emotional distress, defamation or invasion of privacy. SeeDon’t Fail To Consider Taxes When Settling Litigation.

But in 1996, the tax code was changed to say only recoveries for physicalinjuries or physical sickness qualify. Since then, there’s been no end of litigation about the scope of this tax exclusion and just how “physical” injuries must be to count. Headaches and insomnia? Not enough. Ditto for stomachaches. See IRS To Collect on Italian Cruise Ship Settlements.

The IRS hasn’t issued a formal interpretation of the “physical” modifier but routinely argues in audits and tax cases that there must be “observable bodily harm”–think bruises or broken bones. But many injuries are internal and much physical sickness can’t be observed with the naked eye. See Are PTSD Recoveries Tax Free?

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Robert W. Wood practices law with Wood LLP, in San Francisco.  The author of more than 30 books, including Taxation of Damage Awards & Settlement Payments (4th Ed. 2009 with 2012 Supplement, Tax Institute), he can be reached at Wood@WoodLLP.com.  This discussion is not intended as legal advice, and cannot be relied upon for any purpose without the services of a qualified professional.