Does The Revenue Act of 1918 Still Exclude Personal Injury Settlements From Taxable Income?

The exclusion of personal injury awards from taxable income has its historical roots in the Revenue Act of 1918. However, the modern framework for this exclusion is found in Section 104(a)(2) of the Internal Revenue Code (IRC). This section stipulates that damages received on account of personal physical injuries or physical sickness are generally excluded from gross income, meaning they are not subject to federal income tax.

Historical Context

The Revenue Act of 1918 was a landmark piece of legislation that significantly reformed the U.S. tax system. One of its provisions was the exclusion of damages received for personal injuries from taxable income. This was based on the principle that such compensatory damages were meant to make the injured party whole again, rather than to provide a gain or profit. Therefore, it was deemed inappropriate to tax these amounts.

Current Law: IRC Section 104(a)(2)

Today, the exclusion of personal injury awards from taxable income is governed by IRC Section 104(a)(2). This section provides that gross income does not include:

> "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."

This means that if you receive a settlement or judgment for personal physical injuries or physical sickness, the compensatory damages awarded are not included in your taxable income. This exclusion applies to both lump sum settlements and structured settlements where payments are made over time.

Key Points of Section 104(a)(2)

1. Physical Injuries or Physical Sickness: The exclusion specifically applies to damages received on account of personal physical injuries or physical sickness. This includes compensation for medical expenses, pain and suffering, and lost wages resulting from the injury or sickness.

2. Punitive Damages: Punitive damages, which are intended to punish the wrongdoer rather than compensate the victim, are not excluded from taxable income. They are fully taxable regardless of the nature of the underlying injury or sickness.

3. Emotional Distress: Damages received for emotional distress are not excluded from taxable income unless they are attributable to a physical injury or physical sickness. For example, if you receive damages for emotional distress resulting from a traumatic event that also caused physical injuries, those damages may be excluded. However, standalone emotional distress damages are generally taxable.

4. Medical Expenses: If you receive a settlement that includes reimbursement for medical expenses, those amounts are excluded from taxable income as long as you did not previously deduct those expenses on your tax return. If you did deduct the medical expenses in a prior year, the reimbursement is taxable to the extent of the prior deduction.

Practical Examples

Example 1: Car Accident Injury Jane was involved in a car accident and sustained multiple physical injuries. She received a settlement that included compensation for her medical bills, pain and suffering, and lost wages. Under Section 104(a)(2), the entire amount she received for her physical injuries is excluded from her taxable income. However, any punitive damages awarded would be taxable.

Example 2: Emotional Distress without Physical Injury John was wrongfully terminated from his job and suffered severe emotional distress as a result. He received a settlement that included compensation for his emotional distress. Since his emotional distress was not linked to a physical injury or sickness, the damages he received are taxable.

Example 3: Physical Sickness from Toxic Exposure Sarah was exposed to toxic chemicals at her workplace and developed a chronic illness. She received a settlement that included compensation for her medical expenses, pain and suffering, and lost wages due to her illness. These damages are excluded from her taxable income under Section 104(a)(2) because they are on account of physical sickness.

Considerations for Structured Settlements

For claimants who opt for structured settlements, the periodic payments received over time for physical injuries or physical sickness are also excluded from taxable income. This ensures that the tax treatment of the settlement is consistent, regardless of whether the compensation is received as a lump sum or in installments.

Example 4: Structured Settlement for Personal Injury Mike suffered a severe back injury in a construction accident. He agreed to a structured settlement that provides him with monthly payments for the next 20 years to cover his ongoing medical expenses and lost wages. These periodic payments are excluded from Mike's taxable income under Section 104(a)(2), providing him with tax-free financial support over the long term.

Conclusion

The exclusion of personal injury awards from taxable income, originally established by the Revenue Act of 1918 and now governed by IRC Section 104(a)(2), remains a critical provision in the U.S. tax code. This exclusion ensures that individuals who receive compensation for personal physical injuries or physical sickness are not subject to federal income tax on those amounts. By understanding the specific provisions and limitations of this exclusion, taxpayers can better navigate the tax implications of their personal injury settlements and awards.