Tax Memo

Tax Memo

Client: Dr. Smile

Date: March 25, 2015

Facts

Dr. Smile is a well-known dentist in Smallville, TX. At the end of 2014, one of his patient maliciously spread a rumor that he is a carrier of a serious illness. The rumor destroy Dr. Smile reputation and he lost many of his patients. The fear of losing his business and the financial strain caused by this issue badly affected his health.  Dr. Smile developed series of health issues such as migraine headaches, loss of appetite and significant facial twitches. Consequently, Dr. Smile sued the patient for defamation and intentional distress. He won the jury verdict and was awarded a total of $3,600,000 in damages as:

$1,000,000 for lost wages,

$50,000 reimbursement for medical expenses incurred,

$20,000 for future medical expenses anticipated,

$30,000 reimbursement for attorney fees paid,

$2,000,000 in punitive damages,

$300,000 for pain and suffering 

$200,000 as compensation for emotional distress suffered 

Issues

1. Is the entire amount of $3,600,000 that Dr. Smile recovered in damages not taxable?

2.  Is any portion of 3,600,000 taxable? 

Relevant Authorities

IRC Section 104(a) (2)

The amount received from any damages on account of personal injuries or physical injuries. 

IRC Section 62(a) (20)

The definition of “Adjusted Gross income” as gross income minus specified deduction.

Commissioner v. Schleier, 515 U.S. 323, 329-30 (1995)

The court clarified the criteria that must be met in order to exclude damages under IRC Sec 104(a) (2)

Commissioner v. Banks, 543 U.S. 426 (2005).

The court decides on how contingent fees should be calculated on the client income

Guill v Commissioner112 T.C. 325 (1999)

Punitive damages are taxable and included in business income. 

Threlkeld v. Commissioner, 87 T.C. 1294, 1300, 1986 WL 22061 (1986)

The court decides decide whether an amount received related to injury  to the  petitioner's professional reputation arising out of a claim of malicious action is excludable from taxable income under section 104(a)(2).

Analysis of Issues

Issue 1:

Compensation for lost wages is taxable at first. However, under IRC Section 104(a) (2) damages received for tort right is excludable if such tort amount is related to personal injury or sickness. Dr. Smile compensatory damages which include lost wages on account of sickness are excludable from the gross income. It was held by the Supreme Court in the case of Commissioner v. Schleier, 515 U.S. 323, 329-30 (1995) that “medical expenses (not previously deducted), pain and suffering, and lost wages received by an accident victim are excludable from income as on account of personal injuries.” In addition Threlkeld v. Commissioner, 87 T.C. 1294, 1300, 1986 WL 22061 (1986) states that “settlement of a suit for malicious prosecution that represented recovery for injury to petitioner's professional reputation is excludable from income under section IRC Section 104(a) (2)” Reimbursement for medical expenses which incurred when Dr. Smile went to neurologists, internist and psychologist are related to the sickness caused by his patient. Therefore, those expenses will not be taxable. Furthermore, reimbursement of medical expenses satisfied the condition set forth in IRC Section 104(a) (2).  The attorney’s fees paid by Dr. Smile is fully deductible from the income. Dr. Smile won the jury verdict against his patient for defamation. Under to IRC Section 62(a) (20) “the deduction allowed are limited to the amount includible in the litigant’s gross income for the taxable year in which the deduction is being claimed.” Dr. Smile suffered an emotional distress caused by the pressure of losing his practice. The compensation of the emotional distress he suffered is in account to diseases with symptoms such as migraine headaches, loss of appetite and facial twitches. Therefore, the compensation Dr.Smile received will not be included in the taxable income.  In addition, the pain and suffering will not be part of Dr. Smile taxable income. The damages received as a result of personal sickness and personal injury are to be excluded from his tax income.