Rev. Rul. 85-98

1985-2 C.B. 51, 1985-29 I.R.B. 5.

DAMAGES; LIBEL SUIT SETTLEMENT; COMPENSATORY AND PUNITIVE

Published: July 22, 1985

26 CFR 1.104-1; Compensation for injuries or sickness.

(Also Sections 61.212; 1.61-14, 1.212-1.)

  Damages; libel suit settlement; compensatory and punitive. The amount received by an individual in settlement of a libel suit for injury to personal reputation is includible in the individual's gross income to the extent such amount represents the satisfaction of punitive damages. The expenses incurred by the individual that are attributable to the punitive damages are deductible by the individual. Rev. Rul. 58-418 superseded.

ISSUES

  (1) What portion of a settlement, which includes both compensatory and punitive damages, for injury to personal reputation is excludable from the recipient's gross income under the circumstances described below?

  (2) Are the expenses attributable to the amounts received in settlement of the suit deductible for federal income tax purposes?

FACTS

  The taxpayer was the subject of a newspaper article that contained false and defamatory statements that resulted in injury to the personal reputation of the taxpayer as an individual only and did not affect the taxpayer's business or professional reputation. Upon learning of the article, the taxpayer filed in the state court a suit for libel against the reporter who wrote the article and the corporation that published the newspaper. The complaint alleged that at all times prior to the publication of the article, the taxpayer had enjoyed a good reputation for honesty, integrity, and personal character; that as the result of the article's publication the taxpayer had suffered damage to personal reputation, social standing, and family relationships; that the article had caused the taxpayer embarrassment, shame, anxiety, and worry; and that the article had been written and published with actual intent to harm the taxpayer's personal reputation. The complaint asked for compensatory damages of 15x dollars and punitive damages of 45x dollars. The amount of compensatory damages requested relative to the amount of punitive damages request, 1 to 3, bore a reasonable relationship to what a jury might be expected to award under the facts and circumstances of the case. Shortly before trial, the taxpayer and the defendant agreed to a settlement of the libel suit. The taxpayer received a lump-sum payment of 24x dollars in full settlement of all the taxpayer's claims.

  In processing the case through the courts, prior to settlement, the taxpayer incurred and paid various legal expenses totaling 8x dollars. Under the facts and circumstances, it is reasonable to attribute these expenses on a pro-rata basis between the compensatory and punitive damages recovered. That is, the expenses allocable to the recovery of punitive damages bear the same proportion to the total expenses as the punitive damages recovered bear to the total damages received.

LAW AND ANALYSIS

  Section 61 of the Internal Revenue Code provides, in part, that except as otherwise provided in subtitle A, gross income means all income from whatever source derived.

  Section 1.61-14(a) of the Income Tax Regulations states, in part, that punitive damages such as treble damages under the antitrust laws and exemplary damages for fraud are gross income.

  Section 104(a)(2) of the Code excludes from gross income the amount of any damages received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injuries or sickness.

  Section 1.104-1(c) of the regulations provides that the term 'damages received (whether by suit or agreement)' means an amount received (other than workmen's compensation) through prosecution of a legal suit or action based upon tort or tort type rights, or through a settlement agreement entered into in lieu of such prosecution. The regulation makes no distinction between physical or emotional injuries. See Seay v. Commissioner, 58 T.C. 32, 40 (1972), acq., 1972-2 C.B. 3. Punitive damages, however, are not excludable from gross income. See Rev. Rul. 84-108, 1984-2 C.B. 32.

  In Rev. Rul. 58-418, 1958-2 C.B. 18, a taxpayer received an amount in settlement of a libel suit in which the taxpayer had asked for both compensatory and punitive damages. Because of the lack of adjudication, the amount was not distinguished as to the portions allocable to satisfaction of the taxpayer's claim for compensatory damages as distinguished from the taxpayer's claim for punitive damages. The revenue ruling concludes that, inasmuch as the tax consequences attributable to each claim differ, allocation is necessary and proper and that the best evidence available under the facts and circumstances of the case to determine a proper allocation is the taxpayer's complaint.

  In Rev. Rul. 75-230, 1975-1 C.B. 93, a taxpayer received an amount in settlement of a personal injury suit. In determining what part of the settlement amount was allocable to medical expenses incurred and deducted under section 213 of the Code in a prior year, the revenue ruling states that Rev. Rul. 58-418 provides a method of allocation, with respect to settlement of a libel suit, that is based on the best evidence available under the circumstances, which, in Rev. Rul. 58-418, was the relative percentages of the amounts alleged in the complaint. Rev. Rul. 75-230 distinguishes Rev. Rul. 58- 418 based on a conclusion that the best evidence available on which to base an allocation under the facts and circumstances of Rev. Rul. 75-230 is the amount of previously paid medical expenses, which is a sum certain, in contrast with the generally speculative nature of the pain and suffering damages alleged in a personal injury suit.

  In this case, the best evidence available to determine a proper allocation is the taxpayer's complaint, since the amount of punitive damages relative to compensatory damages requested bore a reasonable relationship to what a jury might be expected to award. The taxpayer received a lump-sum settlement amount of 24x dollars. The taxpayer's complaint, however, asked for compensatory damages of 15x dollars and punitive damages of 45x dollars. Thus, the amount of compensatory damages asked equaled 25 percent and the amount of punitive damages asked equaled 75 percent of the total 60x dollars damages asked.

  Section 212 of the Code allows a deduction, in the case of an individual, for all the ordinary and necessary expenses paid or incurred during the taxable year for the production of income.

HOLDINGS

  (1) Inasmuch as the taxpayer's complaint is the best evidence available to determine a proper allocation under the facts and circumstances of the instant case, 25 percent of the 24x dollars settlement amount, 6x dollars, is considered to be in satisfaction of compensatory damages and is excludable from the taxpayer's gross income under section 104(a)(2) of the Code and the regulations thereunder. The remaining 75 percent, 18x dollars, is considered to be in satisfaction of punitive damages and is includable in the taxpayer's gross income under section 61 and the regulations thereunder.

  (2) The expenses incurred and paid to procure the portion of the settlement that is includible in gross income are deductible under section 212 of the Code as ordinary and necessary expenses paid or incurred by an individual for the production or collection of income. Because the expenses are to be allocated between the compensatory and punitive damages on a pro-rata basis, 75 percent of the total 8x dollars expense of procuring the settlement, 6x dollars, is deductible under section 212 of the Code.

EFFECT ON OTHER REVENUE RULINGS

  Rev. Rul. 58-418 is superseded.

Rev. Rul. 85-98, 1985-2 C.B. 51, 1985-29 I.R.B. 5.