The United States Treasury has published new regulations for IRC section 104(a)(2) relating to the exclusion from gross income for amounts received on account of personal physical injuries or physical sickness.
Published January 20, 2012, the new section 104(a)(2) regulations make two primary changes to the current regulations. First, they incorporate amendments to 104(a)(2) made in Small Business Job Protection Act of 1996 (1996 Act). Second, they eliminate the previous regulatory requirement that damages must be based upon “tort or tort type rights” to qualify for the tax exclusion.
The 1996 Act included two legislative amendments narrowing the applicability of the 104(a)(2) exclusion. The first amendment prevents any punitive damages from qualifying for the tax exclusion in the personal injury context. The second amendment requires that injury or sickness damages must result from “physical” origins to be excluded. Although emotional distress is not considered a physical injury or physical illness, the new regulations confirm that damages for emotional distress attributable to a physical injury or physical sickness are excluded from income under section 104(a)(2).
The new section 104(a)(2) regulations also eliminate the previous regulatory requirement that damages must be “based on tort or tort type rights” to qualify for exclusion. In a 1995 case (Commissioner v. Schleier), the United States Supreme Court interpreted this requirement to disallow the exclusion of damages where the relevant law (a "no-fault" statute) provided a contractual remedy even though the claimant suffered a personal physical injury or physical sickness as a result of a breach of contract. The new regulations eliminate this prior requirement and allow the tax exclusion to apply even when the physical injury or sickness does not constitute a tort under state or common law.
The new, final regulations for section 104(a)(2) are essentially the same as the proposed regulations the United States Treasury issued in 2009 and which were the subject of a public hearing on February 23, 2010. The final regulations did not adopt any of the recommendations offered by commentators at the public hearing. These recommendations included:
- Requests by Richard Risk and Jack Meligan that the final regulations address whether a claimant has constructive receipt or the current economic benefit of a damage award that is set aside for the claimant’s benefit in a section 468B qualified settlement fund;
Requests by John McCulloch and David Higgins that the final regulations confirm several specific types of damages are "physical" and therefore tax-exempt.
For background information about the new section 104(a)(2) regulations and their application to structured settlements, including commentary and analysis by Jeremy Babener, see these prior S2KM blog posts:
- Treasury Hearing on IRC 104(a)(2) Regs
- A Common Cause at the Treasury Regulation Hearing
- Treasury Hearing Commentary
- Voices at the Treasury Hearing
- Speaker Comments at the Treasury Hearing
- Legislation to Expand the Structured Settlement Industry
- Babener Proposes Expanded S2 Tax Subsidy
For a copy of the new section 104(a)(2) regulations, see the structured settlement wiki.