Final Regulations Issued on §104(a)(2) Damages for Physical Injuries or Sickness Income Exclusion

The IRS in Treasury Decision 9573 issued in final form revisions to Reg. §1.104-1(c) regarding the exclusion under IRC §104(a)(2) from income of amounts received as damages on account of personal physical injury or physical sickness.

The revisions remove the requirement previously found in the regulations that the damages must arise from “prosecution of a legal suit or action based upon tort or tort type rights, or through a settlement agreement entered into in lieu of such prosecution.”  The new regulations provide that the “exclusion may apply to damages recovered for a personal physical injury or physical sickness under a statute, even if that statute does not provide for a broad range of remedies. The injury need not be defined as a tort under state or common law.”  In the preamble to the final regulations the IRS justified removing the tort test by noting that the case law found in Commissioner v. Schleier, 515 US 323 (1995) and revisions adopted by Congress in 1996 provided definitions that served to clarify the definition of excluded damages that “eliminated the need to base the section 104(a)(2) exclusion on tort cause of action and remedy concepts.”

Reg. §1.104-1(c)(1) clarifies that while emotional distress is not considered a physical injury or physical sickness, damages for emotional distress attributable to a physical injury or physical sickness are excludable from income.

Example – Mary received serious physical injuries in an automobile accident.  In addition to reimbursement for the injuries themselves, a portion of the award is designated to compensate Mary for the emotional distress she underwent due to having to deal with her injuries.  Since the emotional distress can be traced to the physical injury, Mary should be able to exclude that portion of the damages from income in addition to the payments specifically tied to the physical injury.

Example – Bob was subject to illegal harassment on the job which caused him great emotional distress.  His supervisor and various levels of management were aware of the harassment but took no action to stop the harassment.  He brought a claim for damages for the emotional distress and received an award for such damages.  Under the terms of regulations these damages would not qualify for exclusion, but rather would be taxable.

The regulations also note that IRC §104(a)(2) does allow the exclusion of damages related to emotional distress, even if not related to physical injuries, to the extent such damages are not in excess of amounts paid for medical care related to such emotional distress.

The regulation also defines damages to mean an amount received, other than via worker’s compensation, through prosecution of a legal suit or action, or through a settlement agreement entered into in lieu of prosecution.

The revised regulations apply to payments made under a written binding agreement, court decree or mediation award entered into or issued after September 13,1995 and received after January 23, 2012.  However, taxpayers may apply these regulations to amounts under such agreements received after August 20, 1996 and, if the period of limitation on a credit or refund under IRC §6511 has not expired, may, if applicable, file a claim for refund.  The regulation notes that any such claim must meet all of the other requirements of the Congressional law change that placed the “personal physical injuries” requirement into IRC §104(a)(2).

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