Some Lawsuit Awards Are Taxable

QUESTION: I was seriously injured in a freak accident four years ago when a ski fell off a passing car and broke through my windshield. I was out of work for almost a year and felt I had no choice but to file a lawsuit. It was finally settled out of court last month. About three-fourths of the $250,000 settlement reimburses me for my medical bills and for the fact that I have permanent injuries. The rest is for the wages I lost while I was recuperating. Will I be taxed on this settlement--perhaps on the portion that represents reimbursement of lost wages?--R. O.

ANSWER: Breathe easy. The IRS, in a letter ruling earlier this year to a man who received a settlement after he was struck by a bus, says the entire award is non-taxable. That is true even if part of the compensatory damages represents reimbursement for lost wages.

If, however, part of the award is for punitive damages--an award designed not to compensate the winner but to punish the loser in the hopes of preventing similar conduct in the future--then the tax collector will be at your door.

One problem arises here. Unlike an award ordered by a court, which spells out how much is for compensatory damages and what part represents punitive damages, out-of-court settlements rarely provide such a breakdown.

The lawyers representing the two sides will know, of course, whether punitive damages were factored into the settlement. But to place an actual dollar figure on the punitive-compensatory breakdown can be difficult.


So how is the taxpayer to know how much to report to the IRS as punitive damages and, therefore, taxable income? The IRS says the taxpayer’s own demands upon filing the suit are a good guideline. So, if you requested $100,000 in actual damages and $300,000 in punitive damages, the IRS would advise you to apply that same ratio to your actual settlement. Thus, only $62,500 of your award would be for compensatory damages and tax-free, while $187,500 would be for punitive damages and taxable.

Q: I recently accepted a promotion from my company and moved to California from Maine. I had some reservations initially because the type of house I could afford to buy in California was a big comedown for me and my family. But I quickly said yes and sold my house in Maine when my employer offered to provide a house for us. Now I’m beginning to think I accepted that house too quickly. My accountant advises me that I am going to have a huge tax bill if I don’t buy another house with the profits from the sale of my home in Maine. It seems to me that people who move and sell their house to take a new job ought to get some kind of break from the taxes if they have no need for another house right away.--C. P.

A: Even if you were required to move into a company-provided house instead of buying one of your own, you still would not qualify for a tax break unless you replaced your old home within two years. The IRS does grant some special exceptions in cases where a job-related move hinders replacement of the house, but this isn’t one of them.

The only consolation is that you do have two years to make a decision. Maybe you and your family will get tired of the house provided by your employer and decide you would really like to live in a different community. It is also possible, of course, that you will be transferred again or that you will take another job entirely.

Q: I have gotten myself into something of a financial squeeze, and I need to come up with several thousand dollars in about two months. I’m torn because I have the money in my IRA account and I’d rather take it out of there, if I can, rather than borrow the money. Will I just be penalized for doing that or is it actually impossible to get my hands on that money?--R. G.

A: The government can make it painful for taxpayers to lay their hands on money that they have put away for retirement with the help of some government-sanctioned tax breaks. But no one can go so far as to prevent you from helping yourself to your own money.

Should you decide to withdraw part of your IRA funds, you will be required to pay income taxes on the withdrawn money plus a penalty equal to 10% of the withdrawn funds.

Do some calculations. It is possible you will find that this way of solving your cash crunch isn’t a great deal more expensive than borrowing the money.

One other thing you should keep in mind, however, is that you have the right--without penalties this time--to physically withdraw your money from your IRA one time a year, keep it for up to 59 days and then give it over to a different IRA trustee. As long as you place the withdrawn funds into another IRA no later than the 60th day, you avoid all taxes and penalties.

It could be that you will have time to withdraw the money, get through your short-term financial difficulties, replace the funds and have the entire amount back in the hands of an IRA trustee two months later.

Note: A recent column dealing with the taxation of stock options failed to note that the tax consequences detailed apply only to so-called incentive stock options. If the options are so-called non-statutory or non-qualified stock options, another set of rules applies.

Incentive stock options are taxed when the option holder sells the stock acquired through options and not before. But in the case of other types of options, the option holder is taxed when he or she exercises the option.

To determine how much ordinary income he or she must recognize in such cases, the option holder finds the difference between the fair market value of the stock on the date of exercise and the exercise price.

Robert M. Jason, a Los Angeles tax lawyer, points out that, in some rare cases, option holders can even be taxed at the time the option is granted.

Debra Whitefield cannot answer mail individually but will respond in this column to financial questions of general interest. Do not telephone. Write to Money Talk, Business Section, The Times, Times Mirror Square, Los Angeles 90053.