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Five years after the Internal Revenue Code was amended to tax nonphysical damages in personal injury awards and settlements, the Internal Revenue Service is taking the first steps toward knuckling down on enforcement. Upon learning — through an Alabama pilot project that tracked personal injury awards — that no taxes were paid on the vast majority of them, the IRS has issued a training guide for its auditors. The Audit Training Guide, issued in January and posted on the IRS Web site, www.irs.gov, clarifies the code changes and courts’ interpretations of plaintiffs’ tax obligations. While personal injury proceeds are generally not taxable, the 1996 amendments codified in IRC �104 (a)(2) made a distinction between physical and emotional injuries. Damages for nonphysical harm — unrelated to any physical injury, sickness or treatment — are taxable. Punitive damages and interest were taxable before the 1996 changes and remain so. Portions of the proceeds may be treated as ordinary income or as capital gains, depending on the award’s structure and the nature of the underlying claim. The key problem, according to the IRS guide, is that plaintiffs have failed to report proceeds or erroneously classified all or most of the awards as “compensatory” and therefore not taxable. Out-of-court settlements are the most problematic because they are usually a lump sum without any itemization, so it is difficult for plaintiffs to know which portions, if any, are taxable. “These settlements should be closely reviewed,” the IRS guide says. Settlements may be challenged “where the facts and circumstances indicate that the allocation does not reflect the economic substance of the settlement,” according to the guide. For example, a plaintiff who won a settlement for emotional distress might be asked to provide proof of payment for counseling and antidepressants as well as proof of lost workdays. Many lawyers are in the dark about how taxes will affect their clients’ recovery and courts traditionally have shed little light on the subject so confusion persists, says Bruce Mantell, a CPA and partner with the Short Hills, N.J., taxation boutique Mantell Fiszer & Prince. “It’s a murky area,” Mantell says. “This area is an area that is causing a tremendous amount of angst among the attorneys.” It is especially confusing when an award is for multiple claims — some physical and some nonphysical. For example, a worker hurt on the job may be awarded money for the physical injury as well as for back pay. The pay portion is taxable. “It affects the amount of money that gets into the plaintiff’s hands,” says Stephen Vajtay, president-elect of the Taxation Law Section of the New Jersey State Bar Association. “It radically alters the ability to settle.” In some cases, settlements have been jeopardized once litigants realize that the award could be taxed, he says. Vajtay warns that “if many of the plaintiffs’ bar are not aware, they could end up costing their clients a large portion of their settlements.” Attorneys need to know the implications so they can structure the award to their clients’ benefit. Tax attorney Theodore David, a solo practitioner in Hackensack and a former IRS agent, says attorneys have no affirmative duty to advise their clients about tax issues related to recovery. The onus is actually on the other side, he says. Attorneys representing the defendants and insurance companies are required to file a 1099 form with the IRS to report the amounts they have paid. Lauren Handler, a partner with Morristown’s Porzio, Bromberg & Newman, generally tells personal injury clients that they don’t need to worry because the money will not be taxed. But the firm also makes a point of giving clients a document stating that the firm is not serving as tax counsel. Handler finds the IRS inquiries into awards disconcerting. “It just doesn’t make me very comfortable,” she says. “There’s probably a lot of [other] places for them to look to for [revenue] than from injured victims.” Raymond Gill, a partner with Gill & Chamas in Woodbridge, says he usually advises clients to meet with their accountants to determine the possible tax consequences of a settlement or verdict. Defense attorneys at trial often ask judges to let jurors know that most awards are not taxed, Gill says. He opposes that because a jury is more likely to award a higher amount if it thinks the plaintiff will have to pay taxes. The bottom line, says IRS New Jersey spokesman Greg Semanick, is that plaintiffs should consult an authorized tax preparer, not just their attorney.

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