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that the amount of the settlement was negotiated by the parties
and was intended to be “tax free”.
Gross income does not include the amount of any damages
received on account of personal injuries or sickness. See sec.
104(a)(2).7 “The term ‘damages received (whether by suit or
agreement)’ means an amount received * * * 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.” Sec. 1.104-1(c), Income Tax Regs. In order for
damages to be excludable from gross income under section
104(a)(2), the taxpayer must demonstrate that: (1) The
underlying cause of action is based upon tort or tort type
rights; and (2) the damages were received on account of personal
injuries or sickness. See Commissioner v. Schleier, 515 U.S.
323, 337 (1995).
Where amounts are received pursuant to a settlement
agreement, the nature of the claim that was the actual basis for
settlement and not its validity controls whether such amounts are
excludable from gross income under section 104(a)(2). See Seay
v. Commissioner, 58 T.C. 32, 37 (1972). “[T]he critical question
7The Small Business Job Protection Act of 1996, Pub. L. 104-
188, sec. 1605(a), 110 Stat. 1838, amended sec. 104(a)(2) to
limit the exclusion, inter alia, to “personal physical injuries
or physical sickness.” The amendment does not apply to damages
collected before the date of its enactment and has no bearing
here.
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