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Lawsuits, Awards & Settlements Edition

Before You Sign That Settlement Check Make Sure You Give Uncle Sam His Cut!

Do you want to familiarize yourself with the IRS MANUAL written specifically for Internal Revenue Service Audit Agents to use while conducting audits of Lawsuits, Awards and Settlements?

Uncle Sam’s Tax Audit Assistant will provide information on how the Internal Revenue Service identifies tax returns with lawsuit payment issues, suggestions for audit agents conducting the examination, detail of issues, explanations of applicable terminology, synopses of several related court cases, and exhibits of pertinent forms.

The information and techniques presented in Uncle Sam’s Tax Audit Assistant for lawsuit settlement examinations were developed during a project in Alabama, which began with media coverage of relevant tax issues. Analyses of newspaper articles revealed that numerous lawsuits were being resolved in the state either by verdict or settlement for substantial amounts. As a result, a separate project relating only to lawsuit verdicts and settlements was initiated and approved.

This Is The ACTUAL Manual Used To Train IRS Audit Agents in auditing returns involving lawsuits, awards and settlements.

Why You’re A Target NOW?

Early results of the project revealed that the vast majority of these lawsuit verdicts and settlements were escaping taxation. Virtually none of the payments were reported on Forms 1099. For this reason, it has been easy for these payments to fall through the gap of unreported income.

In the examination of returns, it was often found that the taxpayer had classified all or most of the settlement as “compensatory,” usually for “personal injuries,” and therefore arrived at the determination that the proceeds were nontaxable. This pattern was found to be repeated in virtually all of the lawsuit cases, regardless of whether the claims were for fraudulent actions, defamation of character, employment related disputes, product liability, negligence, wrongful death, etc., and also regardless of whether or not claims for punitive damages were involved in the cases.

On the surface, the issue seems quite simpler: Internal Revenue Code (IRC) section 61 states that all income from whatever source derived is taxable, unless specifically excluded by another Code section. In certain situations an amount of a lawsuit settlement might be paid to reimburse a taxpayer for losses, and no gain would have to be recognized under IRC Section 1001 because the amount paid did not exceed the taxpayer’s basis (return of capital). However, the only provision, which specifically addresses income exclusions for any type of lawsuit proceeds, is IRC Section 104(a)(2). Prior to its amendment in 1996, this section excluded from income amounts paid by suit or agreement for personal injuries or sickness. This is the section which taxpayers have most often relied upon for authority to exclude from income lawsuit proceeds of all kinds, including punitive damages. This is where the appearance of a simple issue dissolves.

IRC Section 104(a)(2) has been extensively litigated. The questions have centered on determining “what are personal injuries” for purposes of IRC Section 104(a)(2). The issues have encompassed physical versus non-physical (mental anguish) injuries and sickness, and whether punitive damages are received on account of personal injuries. In 1989, Congress amended IRC Section 104(a)(2) referencing punitive damages and non-physical injuries. However, due to the manner in which the statement was worded, the 1989 amendment only created more controversy. 

The IRS’s current position is that punitive damages are not received on account of personal injuries under IRC Section 104(a)(2), and therefore are not excludable from gross income. In 1996, on the heels of several court decisions that had upheld the IRS’s position, Congress resolved the controversy and amended IRC Section 104(a)(2). 

The 1996 changes clearly provide that punitive damages are not excludable under IRC Section 104(a)(2), regardless of whether received in connection with was physical or non-physical injury or sickness. However, the 1996 amendment to IRC Section 104(a)(2) has raised the issue whether punitive damages received in connection with a wrongful death are excludable from gross income. 

GUARANTEED to be chock-full of ALL of the information you need to survive an audit from the IRS in an easy to understand format!


  • Chapter 1 ISSUES 1-1
    • Issues for Lawsuit Proceeds Received
    • Prior to August 21, 1996 1-1
    • Issues for Lawsuit Proceeds Received
    • After August 20, 1996 1-2
    • Terminology/Definitions 2-1
    • Types of Claims 2-1
    • Types of Damages/Awards 2-2
    • Types of Settlements 2-3
    • Tax Treatment of Awards and Settlements 2-4
    • Payroll and Self-Employment
    • Tax Considerations 3-1
    • Amount to be Included in Income 3-4
    • Deduction for Attorneys’ Fees 3-5
    • Legal Fees Relating to Non-Taxable
    • Awards or Settlements 3-6
    • Accrued Interest on Court Judgments 3-6
    • Newspaper Articles 4-1
    • Courthouse Research 4-1
    • Computerized Data 4-2
    • Settlement Payors 4-2
    • State Department of Insurance 4-3
    • State Supreme Court Library 4-3
  • Chapter 5
    • Third Party Letter 5-1
    • Issuance of Summons 5-2
    • “John Doe” Summons 5-3
    • Third Party Summonses 5-3
    • Other Considerations 5-3
    • Attorney-Client Privilege 5-3
    • References 5-4
  • Chapter 6 BUILDING THE CASE FILE 6-1
    • Identifying the Taxpayer 6-1
    • Information Necessary for the
    • Examination Case File 6-1
    • Scope of Examination 7-1
    • Examination Action Plan 7-1
  • Chapter 8PENALTIES 8-1
    • Reporting of Damage Awards on
    • Forms 1099-MISC 9-1
    • Reporting Payments to Attorneys on
    • Form 1099-MISC 9-2
    • Wrongful Death 10-1
    • Age Discrimination 10-1
    • Sex Discrimination 10-1
    • Discrimination Cases Prior to
    • Burke and Schleier 10-2
    • Employment Related 10-3
    • Legal Fees 10-6
    • Insurance Company Cases 10-6
    • Miscellaneous 10-7
    • Appendix A, Sample Lawsuit Information Data Sheet A-3
    • Appendix B Sample Attachment to Letter A-5
    • Appendix C Information Document Request A-7
    • Appendix D Excerpts from Legislative History of
    • 1996 Amendment A-9

Item #4123009E

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