Damages for personal injuries have been tax exempt from federal income tax since 1996, while money received for emotional distress and other “intangible” injuries had been taxable until the 2006 ruling.
The decision came in the case of Murphy v IRS. Marrita Murphy was awarded a $70,000 judgment for “emotional distress and loss of reputation” by the Department of Labor Administrative Review Board after she “blew the whistle” to authorities about environmental hazards at the New York Air National Guard base where she worked.
The IRS claimed that Murphy owed $20,665 in taxes, plus interest, as a result of her $70,000 award. When the judges agreed with the taxpayer that the settlement was exempt from taxes the IRS asked the full appeals court to consider the matter. Instead, the same three-judge panel decided to rehear the case, and reversed its original decision.
Our fellow blogger Kelly Phillips Erb at TAX GIRL had this to say about the recent decision. I do believe that I agree with her reasoning.
“While I feel for Ms. Murphy (I don’t even want to think what her legal bills are like), I believe that this is the correct ruling. Awards in these kinds of cases are meant to punish the defendant - not give the plaintiff a windfall. In contrast, awards for personal injury are not (in theory) meant to punish the defendant but make the plaintiff whole. Those are different results and should be taxed differently.”
In most cases that result in a legal judgment or settlement, taxable or otherwise, the recipient must pay a substantial percentage of the award to his/her lawyer. A problem arises when it comes to the tax treatment of such “contingent legal fees”.
The US Supreme Court has ruled that individuals receiving a taxable legal award must include the entire amount of the award, including any contingent legal fees and other costs that are deducted from the amount the individual actually receives, in gross income – generally on Line 21 (other income) of Form 1040. The legal fees and costs are deducted on Schedule A as a “miscellaneous deduction” subject to the 2% of AGI exclusion.
Under this treatment the taxpayer is royally screwed. By reporting the gross award on Page 1 his/her AGI is artificially inflated, reducing or eliminating a myriad of tax deductions and credits that are affected by AGI (see my posting on "The Most Important Number on Your Tax Return"). Plus, if the award is substantial enough, the taxpayer will fall victim to the dreaded Alternative Minimum Tax (AMT). Miscellaneous deductions are not allowed in calculating AMT – so the taxpayer gets no tax benefit from the legal fees deducted from the award. Even if not subject to the AMT, the taxpayer will only be able to deduct a portion of the legal fees due to the 2% of AGI exclusion. After paying legal fees and federal and state taxes the poor taxpayer is not left with very much.
However, an “above-the-line” deduction as an “adjustment to income” is allowed for legal fees and costs involved with taxable awards from claims of “unlawful discrimination”. This includes actions related to violations of
· The Civil Rights Act of 1964 and 1991,
· The Congressional Accountability Act of 1995,
· The National Labor Relations Act,
· The Family and Medical Leave Act of 1993,
· The Fair Housing Act,
· The Americans with Disabilities Act of 1990, and
· various whistle blower statutes
As the Murphy case involves a whistleblower action it appears that while Marrita must pay tax on the award she will effectively only pay tax on the “net” amount - after deducting her legal fees and costs.