Structured Settlements - Plaintiff Loyal Structured Settlement Company

Tax Issues for Sex-Abuse Settlements - What Attorneys Need to Know

Image via Wikipedia

IRS Recognizes that the Observable Bodily Harm Requirement may be unfair as applied to Sex Abuse Cases

In 1996, the word “physical” was inserted into IRC 104(a)(2), which essentially mandated that for a settlement to be considered tax-exempt, and eligible for a tax-exempt structured settlement, it must have its origin in physical personal injury or physical sickness. For a settlement to have its origin in physical injury and thus be tax-exempt under IRC 104(a)(2), there must be some Observable Bodily Harm[1] (“OBH”). Some examples of OBH include bruises, scratches, swelling, cuts and bleeding.[2]

Since 1996, the taxation of damages received from sex abuse cases has been particularly problematic. Sex abuse cases inherently involve issues relating to the preservation of evidence of physical harm. By the time the abuse has been reported or the victim can articulate the abuse, any physical injuries may have healed leaving little or no evidence of physical injury. This can make it difficult to meet the OBH standard to satisfy the physical injury requirement of IRC 104(a)(2).

In a February 29, 2008, Internal Legal Memorandum (“ILM”)[3] authored by Michael J. Montemurro, Branch 4 Chief, Income Tax & Accounting Division of the Internal Revenue Service, the IRS recognized this inherent problem of proving OBH in sex abuse settlements.

The ILM reads in relevant part as follows:

“You have inquired about the tax treatment of payments made by Entity to settle claims of Tort asserted by C. C has alleged that Entity’s agent(s) X caused physical injury through Tort while he was a minor under the care of X. A substantial amount of time has elapsed since the alleged Tort occurred. C alleges that he continues to struggle with the trauma resulting from the alleged Tort.

Because of the passage of time and because C was a minor when the Tort allegedly occurred, C may have difficulty establishing the extent of his physical injuries. Under these circumstances, it is reasonable for the Service to presume that the settlement compensated C for personal physical injuries, and that all damages for emotional distress were attributable to the physical injuries. Consequently, the Service should concede that compensatory damages paid to settle the claim are excludable from gross income for federal income tax purposes.

In addition, the Service should not assert that information reporting is required for such payments under section 6041.”

This ILM should not be viewed as a permission slip to abandon good practices and it seeks to guide enforcement policy not to become binding authority.

Additionally, in this ILM C alleged physical injury through Tort as the foundation of his claim. Where Treasury appears to have relented is the OBH proof requirement. It does not excuse the OBH requirement, but recognizes that C may have difficulty establishing the extent of his physical injuries because of the passage of time.

This ILM properly recognizes the challenge of proving OBH inherent in some sex abuse cases due to the nature of the tort, the passage of time, delay in reporting the offense to a parent or authority figure, the youth of the victim, and the inability of the victim to articulate the nature of the abuse or injury due to the age of the victim or the trauma of the offense.

Michael J. Montemurro also confirmed at the Society of Settlement Planners 2008 Annual Educational Seminar in Washington D.C., that the Internal Revenue Service has not asserted in any litigation to date that payments for sexual abuse are taxable income.

The complaint or settlement demand documentation remains a critical piece of the puzzle.

If these documents allege only non-physical injuries such as the intentional or negligent infliction of emotional distress, classifying the damages as taxable is consistent with the pleadings. Therefore, it is important that the complaint or settlement demand documentation contain an allegation of physical injury as the origin of the claim to support the position that the settlement is tax-exempt as being based in physical injury.

Collecting and preserving proof of any physical injury is important if it is available as additional support just in case. Documentation of scratches, bruises, records of a credible pain response from microscopic tissue damage, medical opinions diagnosing an injury should still be collected and maintained in your file if such evidence exists.

When closing a sex abuse case, the negotiation and finalization of the settlement can also help ensure that the damages will be classified as unambiguously tax-exempt. Do the parties, and most particularly the payor, intend the payment as compensation for personal physical injuries?

If so, the settlement documentation should specifically state such intent.

A statement to the effect of, “The parties agree that all sums set forth herein constitute damages on account of personal physical injuries or physical sickness, within the meaning of Section 104(a)(2) of the Internal Revenue Code of 1986 as amended.”

While we still need to follow good business practices, it appears that sex abuse victims can take a sigh of relief when it comes to the taxation of sex abuse settlements when proof of the OBH has dissipated.

Footnotes:

[1] Common sense tells us that some physical injuries are only observable through a detailed medical exam such as a cervical strain (whiplash) from an auto-accident. Certainly, even though the injury is not easy to observe for a person without medical training, it may still be considered a physical injury. Additionally, there is some indication that a credible pain incident may qualify as a personal physical injury.
[1] PLR 200041022

**Be sure have an expert Plaintiff Loyal Settlement Planner on your side to protect your client’s interests, limit your liability, and counteract the settlement expert retained by the defense. Give us a call anytime at 800-666-5584.