Should a Payment to Settle a Disability Insurance Lawsuit be Includible in Income?

Posted on January 15, 2015

The taxpayer was covered through his employer under a group long-term disability insurance policy. He did not pay any portion of the premiums and the value of the payments made by his employer for policy coverage were not included in his income.

The taxpayer was subsequently diagnosed with Bell’s palsy which lead to his inability to work. He began receiving short-term disability payments from the disability insurance company.

After the short-term disability payments stopped, the taxpayer filed a claim with the insurance company for long-term disability benefits. Unfortunately, the insurance company denied the taxpayer’s claim for long-term disability benefits. The taxpayer then sued the disability insurance company because of the rejection of his claim for long-term disability benefits.

In order to settle the lawsuit, the disability insurance company made a payment to the taxpayer in the amount of $65,000.00. The taxpayer subsequently filed his tax return for that year and acknowledged receipt of the payment from the disability insurance company in the amount of $65,000.00.

However, he did not report the payment in the amount of $65,000.00 as income on his tax return. The IRS took the position that the payment should be includible income and issued a Notice of Deficiency to the taxpayer.

The taxpayer subsequently filed a Petition in the United States Tax Court. The Tax Court ruled in favor of the IRS, holding that the payment made in response to the taxpayer’s lawsuit against the disability insurance company should be treated as income. Internal Revenue Section 104(a)(2), Compensation for Injuries and Sickness typically excludes from gross income any payment made on account of personal physical injuries. Because the payment was made stemming from a lawsuit because the insurance company rejected of the taxpayer’s claim for long-term disability benefits and because the payment was not made as a result of physical injuries, the payment to the taxpayer by the insurance company was treated as income.