Can Malpractice Settlements Be Taxable?

Is a settlement of a malpractice claim against physicians or a hospital considered to be taxable income? 

In short, it depends, but according to a recent Tax Court and Ninth Circuit Appeals Court case, it can be. Let’s dig in…

Background: Generally, legal awards and settlements are subject to federal income tax, like most other forms of income. However a special section of the tax law specifically excludes from tax damages that are received on account of personal physical injuries or illness.

This issue is often contested in the courts when a taxpayer receives a settlement or other damages based on a claim of emotional distress. The new case at hand involves a settlement of a malpractice lawsuit. In this instance, the taxpayer was hurt when she sat in a broken wheelchair at a hospital.

She sued the hospital and lost, but then claimed malpractice by her attorneys and eventually agreed to a settlement. The Tax Court determined that the payment constituted taxable income.

To exclude income under Section 104(a)(2) of the Tax Code, a taxpayer must show

1. That the underlying cause of action giving rise to the recovery is based upon tort or tort-type rights

2. That the damages were received on account of personal physical injuries or physical sickness

Note: The second requirement can only be satisfied if there is a “direct causal link” between the damages and the personal injury that was suffered.

In the context of a settlement agreement, a taxpayer can establish a direct causal link through the express terms of the agreement or, if the terms of the agreement are unclear, by the intent of the payors.  In this case, the express terms of the taxpayer’s settlement agreement made it clear that there was no direct causal link between the legal malpractice settlement and her physical injuries.

The settlement agreement expressly states that the taxpayer and her attorneys maintain that she didn’t sustain any physical injuries as a result of the alleged negligence of either of her attorneys. The agreement further states that it was entered into “for the purpose of compromising and settling the [malpractice] dispute between [the parties].”

Taken together, the terms of the agreement demonstrate that the settlement was entered to compensate the taxpayer for the harm caused by her lawyers’ legal malpractice, rather than the physical injuries she sustained in her underlying negligence action. Accordingly, the Ninth Circuit Court affirmed the Tax Court’s decision.