In a 2010 article titled "How Plaintiffs Might Receive Emotional Distress Damages Tax-Free After 2010", published in the "North Carolina Lawyers Weekly", Jeremy Babener asked a pointed and strategic question: how can the structured settlement industry encourage more damages to be received tax-free? Doing so, presumably, would expand the structured settlement market.
Several proposals to accomplish these objectives have been offered during the past few months - some of which resulted from a U.S. Department of the Treasury public hearing held on February 23, 2010 to consider proposed new Treasury regulations for IRC section 104(a)(2). If adopted, these proposed new Treasury regulations would make two primary changes to current regulations:
- Eliminate the requirement that damages be based on “tort or tort type rights” in order to qualify for the section 104(a)(2) tax exclusion, and
- Incorporate 1996 legislation requiring that personal injuries and sickness damages be “physical” in order to qualify for the section 104(a)(2) exclusion.
In the context of these proposed new Treasury regulations, the structured settlement industry would benefit from greater discussion and a better understanding of the following recent tax proposals to expand application of the section 104(a)(2) tax exclusion:
- The National Taxpayer Advocate, which considers taxpayer considerations from inside the IRS, has recommended that section 104(a)(2) exempt non-physical damages, specifically emotional distress, mental anguish, and pain and suffering.
- John McCulloch proposed, during the February 23, 2010 public Treasury hearing, that damages received by victims of prolonged sexual abuse or false imprisonment should always be deemed “physical” for purposes of IRC section 104(a)(2) whether or not evidence is available to demonstrate physical injury.
- Richard Risk and Jack Meligan each recommended, during the same public hearing, that Treasury issue regulations explicitly holding the economic benefit doctrine will not be triggered in the context of single-claimant 468B Qualified Settlement Funds.
- David Higgins has proposed two recent tax recommendations. In a written submission for the Treasury public hearing, Higgins argued that the IRS’ definition of "physical" is inadequate: “direct unwanted or uninvited physical contacts resulting in observable bodily harm such as bruises, cuts, swelling, and bleeding.” Higgins recommends a broader definition, including damages for:
- A doctor’s misdiagnosis resulting in death or serious injury from delayed or missing treatment;
- Child neglect resulting in starvation or illness;
- Rape committed under threat of bodily harm; and
- Other situations where traditional physical injury torts occur without unwanted or uninvited physical contact or observable bodily harm.
- Higgins directed his second recommendation to Senator Max Baucus (Chairman of the Senate Finance Committee), Congressman Dave Camp (Chairman of the House Committee on Ways and Means), and Michael Mundaca (Assistant Secretary of the Treasury for Tax Policy). In his communication, Higgins recommended a "rollover provision" to replace Section 130 of the Tax Code. Higgins' proposal would allow personal injury plaintiffs to accept a check from defendants and invest the money within a given period (likely limiting the investment options to annuities and Treasury bonds), without losing the tax benefit currently available to them only by agreeing to a structured settlement with a counter-party.
- Jeremy Babener has proposed a legislative conversion of the structured settlement exclusion to a refundable tax credit. The premise of Babener's proposal is that high-income taxpayers benefit more from the structured settlement subsidy than low-income taxpayers, who sometimes do not benefit at all. A refundable tax credit would provide the same incentive value to all structured settlement recipients, high-income or low-income.
Most recently, McCulloch has incorporated his earlier recommendations into a request to Treasury and the IRS that final regulations under IRC Section 104(a)(2) should clarify the scope of the exclusion for damages received on account of personal "physical" injuries or "physical" sickness. McCulloch's request seeks guidance and a determination as part of Treasury's 2011-2012 Guidance Priority List that sexual abuse cases and long-term wrongful incarceration (at least one year of restraint) are per se physical injuries under Section 104(a)(2).
In support of his proposal, McCulloch states: "There is a significant body of literature that recognizes sexual abuse as a serious medical problem with long lasting and severe physical effects, many of which can only be treated by a licensed medical practitioner or through the prescription of controlled medications. There are similar medical studies that demonstrate the persistent physical damage that results from long-term incarceration."
The purpose of the Treasury's Priority Guidance Plan is to focus United States government resources "on guidance items that are most important to taxpayers and tax administration." In reviewing recommendations and selecting projects for inclusion on the 2011-2012 Guidance Priority list, the Treasury and the IRS have stated they will consider whether the recommended guidance:
- Resolves significant issues relevant to many taxpayers;
- Promotes sound tax administration;
- Can be drafted in a manner that will enable taxpayers to easily understand and apply the guidance;
- Involves regulations that are outmoded, ineffective, insufficient, or excessively burdensome and that should be modified, streamlined, expanded, or repealed;
- Reduces controversy and lessens the burden on taxpayers or the IRS; and
- Whether the IRS can administer the recommended guidance on a uniform basis.
McCulloch maintains his request for guidance satisfies the above criteria:
- Since Section 104(a)(2) was amended in 1996, taxpayers have needed guidance to determine the scope of the terms "physical injury" and "physical sickness" for which no definitions exist.
- The 1996 amendment did not specifically consider its application to victims of sexual abuse and wrongful incarceration and needs modification because it affects a large and growing number of taxpayers:
- For sexual abuse victims, because of greater opportunities for victims resulting from legislation in many states which extends applicable statutes of limitations.
- For wrongful incarceration victims, because more widely available DNA-testing absolves wrongfully convicted prisoners.
- The requested guidance would promote sound tax administration by providing an understandable tax rule thereby minimizing the likelihood of future controversies.
- It would also provide consistency in tax treatment among such victims who face uncertainties and expense when they currently attempt to address these issues individually.
In S2KM's opinion, industry support for McCulloch's proposal would provide one immediate answer to Jeremy Babener's strategic question about how the structured settlement industry can cooperate to improve and grow its market by encouraging more damages to be received tax-free under IRC section 104(a)(2).
For additional information about taxation of damages received by personal injury victims, see Chapter 2 of "Structured Settlements and Periodic Payment Judgments" (S2P2J)