Ampersand LLP
Beaumont, TX

TO: Partner
FROM: Staff Accountant
DATE: March 24, 2016
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SUBJECT: Memorandum Privileged and Confidential

Relevant Facts
In 2013, Mr. Hobby suffered serious bodily injury while working at a local refinery in Beaumont. On his 2013 tax return, he deducted medical expenses of $25,000. On his 2014 tax return, he deducted medical expenses of $15,000. In 2015, Hobby won a civil lawsuit connected to his injury in 2013. He was awarded as follows: Punitive damages $150,000.00, reimbursement of medical expense $40,000.00, emotional distress $75,000.00, pain/suffering $200,000.00, interest $7,500.00, and attorney’s fees $25,000.00, totaling $497,500.00.

Specific Issues
Which portion of the award for damages is taxable in 2015?

Support and Analysis
Per IRC §104(a)(2), any damages (excluding punitive) received on account of personal physical injury are excluded from gross income. Therefore, both $75,000 for emotional distress and $200,000 for pain and suffering are a result of the injury and can be excluded from income. Treas. Reg. §61.1-14(a) specifies “for example, punitive damages…are gross income” meaning that the $150,000 of punitive damages from this lawsuit are considered gross income. These are considered income because the punitive award is primarily to punish the wrongdoer, and is not compensatory for the physical injury.

However, IRS publication 4345 (Rev 4-2015) explains that income received for reimbursement of medical expenses that were deducted in previous returns must now be included in gross income for the current year, because the taxpayer has already enjoyed the benefit of medical expenses write-off previously and cannot “double dip”. This is backed up by a court case U.S. v. Schleier [95-1 USTC ¶50,309] where Schleier was allowed deductions in previous years for medical expenses and the court then held his reimbursement for those expenses as taxable in the current year. $40,000 of the settlement goes back into gross income for medical expenses.

Treas. Reg. §61.1 defines gross income as “all income from whatever source derived, unless excluded by law”. Although physical injury damages are protected, IRC §61(a)(1) lists compensation for services or fees as taxable. The settlement included repayment of $25,000 for attorney’s fees, which are taxable. In addition, IRC §61(a)(4) specifically lists out interest income as taxable. The $7,500 in interest gained from the settlement is subject to tax.

IRC §265(a)(1) restricts the deductibility of expenses related to exempt income, but because not all of the settlement was exempt, IRC leaves room for a portion of the legal fees to be deductible according to the amount of the full settlement that is taxable. The percentage is based on the taxable income, divided by the full settlement, and then multiplied by the amount of attorney fees incurred. That total is deductible against the taxable portion of the settlement. 45% of the full settlement (punitive $150,000, medical $40,000, interest $7,500, and attorney fees $25,000) is currently taxable, which allows for that portion of the $25,000 to be deducted. Therefore, $11,250 is deductible for taxable attorney’s fees.

Conclusion
The emotional distress and pain and suffering can be left out of gross income for the 2015 tax return. Punitive damages, reimbursement of medical expenses, attorney’s fees, and interest are all taxable, which increases gross income by $222,500. However, a partial deduction for legal fees of $11,250 can be taken on the taxable percent of the settlement to reduce new gross income to $211,250.

Actions to be taken
Prepare letter, review results with client.
Preparer: Staff Accountant
Reviewer: Partner