Tax Ramifications in Sex Abuse Cases

We learned a great number of valuable lessons from a recent case against a Native American Tribe and wanted to make sure to pass on at least one of these lessons here. I’ll just mention one for this post and perhaps save the rest for future posts: Remember to think about taxes, especially if you want a settlement to be considered tax-exempt.

A recent case involved a client, who was raped by a juvenile offender. That juvenile was a member of a Native American tribe and had a long list of criminal convictions who had been subject to an equally long list of court orders and restrictions. As a ward of the tribe, his actions were under the control of the tribe’s Indian Child Welfare Department. We thought the department had abrogated its responsibilities and acted negligently in several of its decisions and actions, which all led inexorably to the rape of our client. We decided to sue the tribe for the injuries our client suffered. We eventually settled the case for $1 million

Here’s where the issue of taxes enters the picture: In 1996, the “physical” was inserted into the Internal Revenue Code 104(a)(2), requiring that for a settlement to be considered tax-exempt and eligible for a tax-exempt structured settlement, it must have its origin in physical personal injury or physical sickness.  For a settlement to have its origin in physical injury and thus be tax-exempt under IRC 104(a)(2), there must be some Observable Bodily Harm (“OBH”).  Some examples of OBH include bruises, scratches, swelling, cuts and bleeding.

Since 1996, the taxation of damages received from sex abuse cases has been particularly problematic.  Sex abuse cases inherently involve issues regarding the preservation of evidence of physical harm.  By the time the abuse has been reported or the victim can articulate the abuse, any physical injuries may have healed leaving little or no evidence of physical injury.  This can make it difficult to meet the OBH standard to satisfy the physical injury requirement of IRC 104(a)(2).

The complaint or settlement demand documentation remains a critical piece of the puzzle.  If these documents allege only non-physical injuries such as the intentional or negligent infliction of emotional distress, classifying the damages as taxable is consistent with the pleadings.   Therefore, remember to include details of physical injury as the origin of a claim in your complaint or settlement demand, to support the position that the settlement is tax-exempt as being based in physical injury.  Also remember to collect and preserve proof of any physical injury whenever possible, as additional support just in case. 

When closing a sex abuse case, the negotiation and finalization of the settlement can also help ensure that the damages will be classified as unambiguously tax-exempt.  Do the parties, and most particularly the payor, intend the payment as compensation for personal physical injuries?  If so, the settlement documentation should specifically state such intent.  Be sure that you insert the necessary language in your pleadings and in any settlement documents in order to avoid adverse tax consequences.


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