A Common Cause at the Treasury Regulation Hearing

Written by Jeremy Babener, S2KM Contributing Author

As written previously, the Treasury will be holding a hearing on its proposed regulations for section 104(a)(2) on February 23, 2010. The proposed regulations, set forth in a nutshell:

• 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) tax exclusion.

Ordinarily, industry spokespersons attending would be expected to comment on “what is on the table.” However, the ongoing debate of the single-claimant qualified settlement fund issue has become of central concern for many in this industry. Richard Risk, structured settlement attorney and founder of the Society of Settlement Planners (SSP), and Jack Meligan, settlement planner and founding President of SSP, posit that the Treasury should issue regulations in favor of single-claimant qualified settlement funds. Joseph Ricci, Executive Director of the National Structured Settlements Trade Association (NSSTA), and John Stanton, counsel for NSSTA at Hogan & Hartson, argue otherwise. However, this debate focuses on hypothetical regulations that the Treasury has not proposed.

While the single-claimant issue is of much importance, the structured settlement industry should not lose sight of its chance to influence the regulations actually proposed by the Treasury. Most importantly, those at NSSTA, the SSP, and the National Association of Settlement Purchasers (NASP), should consider working with those at the American Association for Justice (AAJ), and the National Employment Lawyers Association (NELA), who all have a common interest at the Treasury hearing: expanding the applicability of the section 104(a)(2) exclusion. Decreased taxation of damages means larger after-tax recoveries for plaintiffs, more sales for life insurance companies, and presumably, more factoring transactions. By uniting, the structured settlement industry, in tandem with AAJ and NELA, will be better able to further all interests involved (other than increasing government revenue).

John McCulloch, Vice President of Integrated Financial Settlements, and David Higgins, attorney at Higgins Settlement Law, have both written to the IRS in this vein. Both have argued for the explicit confirmation of several types of damages as “physical,” and thus tax-exempt. Most of the letters submitted to the Treasury are available at regulations.gov .

Higgins’ Proposal for the “Physical” Requirement
Higgins argues 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.” He recommends a broader definition, including damages for:

1. a doctor’s misdiagnosis resulting in death or serious injury from delayed or missing treatment,
2. child neglect resulting in starvation or illness,
3. rape committed under threat of bodily harm, and
4. other situations where traditional physical injury torts occur without unwanted or uninvited physical contact or observable bodily harm.

McCulloch’s Proposal for the “Physical” Requirement
McCulloch proposes two specific examples for the IRS to include in its regulations. Examples are often found in Treasury regulations, and are used to show how the law and regulations are to be interpreted in varying situations. McCulloch's first example, if accepted, would hold that damages for emotional distress from an extended period of sexual abuse, even without proof of “observable bodily harm,” are received by plaintiff tax-free. His second example would hold that damages for wrongful imprisonment of more than one year, including a portion for resulting emotional distress, are received by plaintiff tax-free.

McCulloch's examples are based in prior IRS decisions, building on them to expand the applicability of section 104(a)(2)’s exclusion.

McCulloch's First Example (Sexual Abuse)
McCulloch notes that his first example (sexual abuse) “loosely tracks the fact pattern and conclusion reached” in a 2008 IRS Chief Counsel Advice Memorandum. There are two key differences. First, the example concerns a law suit filed “[s]ometime after” the original tort. In the 2008 memo, the law suit was not filed for a “substantial time” after the original tort. Second, McCulloch's proposal holds such damages to always constitute physical injury. The 2008 memo, noting that the substantial time lag meant that the taxpayer might have difficulty establishing the extent of his physical injuries, held that it was reasonable for the IRS to presume that the settlement compensated taxpayer for personal physical injuries. The first example thus “loosely tracks” the memo, attempting to expand its applicability, and strengthen its force.

McCulloch's Second Example (Wrongful Imprisonment)
McCulloch suggests that although there have been no observable injuries in his second example (wrongful imprisonment), “the act of physical restraint in a prison cell in this situation is inherently a type of physical injury.” He believes this to be consistent with the Civil Liberties Act of 1988, which provided tax-free compensation to Japanese-Americans wrongfully imprisoned during World War II. He also argues that his example is consistent with the Tax Court’s Stadnyk v. Commissioner decision, which held damages for eight hours of false imprisonment to not constitute a physical injury.

His argument makes two taxpayer-friendly moves from the World War II and Stadnyk cases. First, the World War II decisions were made prior to the 1996 legislation requiring personal injury damages to be “physical” in order for plaintiffs to receive them tax-free. Thus, they may be no more relevant than other pre-1996 cases not requiring injuries to be “physical.” Second, the Stadnyk case, which held the eight-hour wrongful imprisonment damages to be taxable, in no way limited its decision to short-term cases. In fact, the Tax Court provided seemingly timeless language: “Physical restraint and physical detention are not ‘physical injuries’ for purposes of section 104(a)(2)….Nor is the deprivation of personal freedom a physical injury for purposes of section 104(a)(2).” McCulloch’s example and comment would create new law (since the 1996 legislation), expanding the types of damages eligible for the tax exemption.

Further Work Before the Hearing
In cooperating, the relevant associations might consider additional proposals for the IRS based on last month’s decision, Domeny v. Commissioner (T.C. Memo 2010-9). There, the Tax Court held that damages were received tax-free when made by a defendant for the causing of an acute physical illness by a stressful work environment. Proposals and examples consistent with this decision may be well aimed to preserve or expand the tax-exempt status of several types of personal injury damages.

S2KM Footnote:

• Jeremy Babener and S2KM Limited have agreed to feature occasional articles written by Babener on S2KM's blog. Except for articles including Jeremy Babener's byline or interviews featuring Babener, he does not contribute to or endorse S2KM opinions or writing.
• Babener is a third year law student at NYU School of Law, and has written extensively about structured settlements (articles available at TaxStructuring.Com).