IRS issues final regs on exclusion of damages for personal physical injury

January 20, 2012

The IRS on Friday issued final regulations relating to the exclusion from gross income for damages received on account of physical injuries or sickness (T.D. 9573). The regulations remove the requirement that damages received from a legal suit, action or settlement must be based on “tort or tort type rights” in order to be excludible. The final regulations adopt without substantive change regulations proposed in 2009 (REG-127270-06).

In response to controversy over the issue of which damages for personal injury were excludible from income under Sec. 104, in 1996, Congress amended the law to preclude exclusion from income for damages received for other than “personal physical injuries or physical sickness” (Small Business Job Protection Act, P.L. 104-188, §1605). The legislation also clarified that emotional distress should not be treated as a physical injury or sickness, except that damages paid for medical care attributable to emotional distress was excludible.

The law was generally effective on the date of enactment (Aug. 20, 1996), but it had an exception for certain payments received under certain types of binding agreements in effect on Sept. 13, 1995.

The original regulations that the IRS issued under Sec. 104 required that, to be excludible, the damages had to be based on “tort or tort type rights” (Regs. Sec. 1.104-1(c)), which was intended to distinguish between damages for personal injuries and other types of damages such as damages for breach of contract.

The IRS explained in the preamble to the final regulations issued Friday that there is no need to limit the type of action because Sec. 104(a)(2) limits the exclusion to damages for personal physical injury or physical sickness. The regulations also permit the exclusion of damages for emotional distress, to the extent the emotional distress is attributable to a physical injury or physical sickness, and also permit the exclusion of damages that do not exceed the amount paid for medical care for emotional distress (Regs. Sec. 1.104-1(c)(1)).

The regulations adopt the effective date provision that was built into the 1996 legislation, permitting taxpayers to apply the rules to damages received after Aug. 20, 1996, under an agreement, decree or award entered into or issued after Sept. 13, 1995, and to apply for a refund if applying the rules results in an overpayment of tax (Regs. Sec. 1.104-1(c)(3)). However, since the refunds are subject to the statute of limitation under Sec. 6511 (generally three years since filing/two years since payment), this generous rule will have limited application to damages awarded in the past.

Sally P. Schreiber ( sschreiber@aicpa.org ) is a JofA senior editor.

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