Situation:
An individual was injured picking up heavy material while performing his duties at work.
After the injury, he sought medical attention that was covered by his health insurance policy. During the course of his treatment, he had multiple surgeries and was missed time at work.
His employer provided the individual with a lump-sum payment of approximately $35,000 during the first year of his disability, which he declared as income when he completed his tax return.
Then, after his medical professional ruled that he would be unable to return to his prior position due to the physical activity that was required, his employer decided to offer him a disability settlement.
The individual has requested your advice as to the best way to take the lump-sum distribution from the company.
The company has offered to make the payment over three years to help alleviate any tax burden your client may face.
Solution:
Two Internal Revenue Code sections should be reviewed when considering the answer to this situation. The first is Section 61, which defines gross income as all income from whatever source, except those items specifically excluded by the code.
So, at first glance, you would expect that the lump-sum distributions would be included in your client’s income.
However, Section 104(a)(2) specifically excludes amounts received as damages on account of a physical injury or a physical sickness.
On Aug. 22, 2006, the U.S. Circuit Court of Appeals for the District of Columbia Circuit, in
Murphy vs. Internal Revenue Service, ruled that compensation received on account of a non-physical injury was excludible from gross income.
However, in the Tax Court case
Murphy vs. IRS, the court abandoned its previous ruling and avoided addressing the issue of whether such compensation is includible in gross income.
The court held that a tax on awards for non-physical injuries falls within Congress’ power to tax under Article I, Sections 8 and 9 of the U.S. Constitution.
The court likened the tax on Murphy’s award to an excise tax, which is an indirect tax not subject to the requirement of apportionment, but which operates with the same force and effect throughout the United States and therefore satisfies the requirement of uniformity.
As a result, it was determined that compensation received on account of a non-physical injury or sickness was indeed taxable compensation under Code Section 61.
Your client was physically injured while at work, thus qualifying for disability income.
Code Section 104(a)(2) specifically excludes amounts received as damages on account of a physical injury.
Your client did not receive compensation for any emotional distress or injury.
The employer and your client entered into an agreement for a settlement due to the physical injury.
For tax purposes, there is no advantage to spreading the payments out over three years.
The question becomes, is it better for investment purposes to have the client receive the lump-sum payment in one year versus three years?
As the old adage goes, a bird in hand is better than two in the bush.
It is recommended that the client take the lump-sum settlement payment the first year available.
In addition, the prior-year tax return should be amended since the amount included in gross income was received as an agreement due to a physical disability.
Tax INsight is prepared by experts who are active members of the American Institute of Certified Public Accountants. Tax INsight appears on the web and in IN Daily every Tuesday. Comments are welcome at
IN_Editor@InvestmentNews.com.
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