Medical Malpractice I want to sue my dentist

[rabakh]

Thank you all. This is very helpful and a lot to understand. You all are very generous with your time and expertise.

 

[Tax Counsel]

The overly simplistic answer to this question is that any compensation you receive for lost wages may be taxable (although I see that this contradicts what "Tax_Counsel" wrote, so hopefully he'll clarify and correct this).

A lot of people who are not tax lawyers, including a lot of lawyers who don't specialize in tax, assume the same thing you did. It's not surprising. After all, initially it makes a certain amount of sense. Wages are taxable income after all, so it would seem logical that the portion of a personal injury award that is meant to compensate for wages would also be taxed.

However, that is not what the tax law provides. The federal tax law starts with the idea that everything you receive is taxable income unless the Internal Revenue Code (IRC) provides for an exemption.

The exception that applies in this situation is IRC § 104(a)(2), which exempts "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."

So the exception is limited to damages received on account of personal injuries or physical illness but does not include punitive damages. The phrase "on account of" means any damages that are due to the physical injury, regardless of the nature of the loss, i.e. medical bills, lost wages, lost business income, pain and suffering, or whatever. As long as those damages are traced to the physical injury they are not subject to tax, with the exception of punitive damages and certain interest. The U.S. Supreme Court explained the exemption quite well stating:

Consideration of a typical recovery in a personal injury case illustrates the usual meaning of "on account of personal injuries." Assume that a taxpayer is in an automobile accident, is injured, and as a result of that injury suffers (a) medical expenses, (b) lost wages, and (c) pain, suffering, and emotional distress that cannot be measured with precision. If the taxpayer settles a resulting lawsuit for $30,000 (and if the taxpayer has not previously deducted her medical expenses, see § 104(a)), the entire $30,000 would be excludable under § 104(a)(2). The medical expenses for injuries arising out of the accident clearly constitute damages received "on account of personal injuries." Similarly, the portion of the settlement intended to compensate for pain and suffering constitutes damages "on account of personal injury." Finally, the recovery for lost wages is also excludable as being "on account of personal injuries," as long as the lost wages resulted from time in which the taxpayer was out of work as a result of her injuries. ​

Comm'r v. Schleier, 515 U.S. 323, 329, 115 S. Ct. 2159, 2163–64, 132 L. Ed. 2d 294 (1995). Note the last sentence from quote above: the lost wages are excluded from income as long as the lost wages were due to time that the taxpayer was out of work as a result of his/her injuries.

The rule is one that, with a few minor adjustments, has been around for decades. The IRS stated the same rule in Revenue Ruling 85-97: "The entire amount received by an individual in settlement of a suit for personal injuries sustained in an accident, including the portion of the amount allocable to the claim for lost wages, is excludable from the individual's gross income. Rev. Rul. 61-1 amplified." That ruling is still good today, though with the change that the portion of the award for punitive damages is not excluded from income. The punitive damage rule was added to the statute after this ruling was issued.