TO: XYZ
FROM: Sandra M. Rodriguez-Diaz, Esq.
DATE: October 8, 2007
RE: Pain and Suffering and Wrongful Death Causes of Actions – Analysis of Income and Estate Tax Issues
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In accordance with the United States Treasury Department Circular 230, I advise you that any discussion of a federal tax issue in this communication is not intended or written to be used, and it cannot be used, by any recipient, for he purpose of avoiding penalties that may be imposed on the recipient under United States federal tax laws.
I. Facts
Decedent died as a result of massive injuries and burns sustained in a car accident, in 2004. The defendant owned the car that impacted decedent’s car.
At the time of his death, decedent was survived by his wife and three adult children.
Decedent, who was a U.S. citizen, died intestate. Decedent’s wife and three adult children are his only distributees. Decedent’s wife is a permanent resident of the United States.
The firm of W, Y & Z. brought an action for decedent’s injuries and pecuniary damages on behalf of the four distributees. No derivative action was brought on behalf of the widow for loss of services and consortium.
The claim was settled for $2,500,0000.00 (gross amount). After deducting the amount of $838,539.39 for legal fees and disbursements there is a balance of $1,661,460.61 to be allocated to each of the following causes of action: (1) decedent’s conscious pain and suffering and (2) pecuniary losses of the four distributees.
Drafts of estate tax returns at the federal and NY State levels have been prepared but have not yet been filed. I have not had the opportunity to determine the accuracy and completeness of the information in these drafts of the estate tax returns.
II. Issues
1) Whether the damage award for the decedent’s pain and suffering that the distributees may receive from decedent’s estate is included in their gross income and thus, taxable as ordinary income at the federal, NY State, and local levels?;
2) Whether the damage award for pecuniary losses that the distributees may receive in their wrongful death cause of action against defendant is included in their gross income and thus, taxable as ordinary income at the federal, NY State, and local levels?
3) Whether the damage award for the decedent’s pain and suffering that the decedent’s estate may receive is included in the decedent’s gross estate for estate tax purposes at the federal and NY State levels?;
4) Whether the damage award for pecuniary losses that the distributees may receive in their wrongful death cause of action against defendant is included in the decedent’s gross estate for estate tax purposes at the federal and NY State levels?
5) Whether a federal and/or NY State estate tax returns are required to be filed?
6) If a federal and/or NY State estate tax returns are required to be filed, will the transfer of property to decedent’s surviving spouse qualify for the federal estate tax unlimited marital deduction causing the reduction or elimination of any estate tax liability due?
7) What is the most beneficial allocation to the decedent’s surviving spouse of the proceeds that she may receive from the decedent’s estate for the estate’s cause of action for his pain and suffering and the proceeds that she may receive as a distributee from the distributees’ cause of action for decedent’s wrongful death?
III. Law and Analysis
Internal Revenue Code (“IRC”) § 61 (a) states that “except as otherwise provided” for the purposes of calculating federal income tax the term “gross income” includes “all income from whatever source derived.”
The exclusions from gross income are to be narrowly construed.[1]
IRC § 104 (a)(2)[2] excludes from income the amount of any damages (other than punitive damages) received on account of personal physical injuries or physical sickness, regardless of whether such amounts are received by suit or agreements and whether as lump sums or as periodic payments.
The regulations under § 104 provide 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.”[3]
Emphasizing the requirements stated in IRC § 104 (a)(2) and the regulations under § 104, the Supreme Court of the United States (the “Court”) held in Commissioner v. Scheleier, 515 U.S. 323, 337 (1995), that two independent requirements must be met for a recovery to be excluded from income under IRC § 104 (a)(2):
First, the taxpayer must demonstrate that the underlying cause of action giving rise to the recovery is “based upon tort or tort type rights.” In United States v. Burke, 504 U.S. 229 (1992) the Court concluded that in order for the first requirement to be met the relevant cause of action must provide the availability of a broad range of damages, such as damages for emotional distress, pain, and suffering.
Second, the taxpayer must show that the damages were received “on account of personal injuries or sickness.” In Schleier, the Court illustrated the application of the second requirement by way of an example in which a taxpayer who is injured in an automobile accident sues for (1) medical expenses, (2) pain, suffering, and emotional distress that cannot be measured with precision, and (3) lost wages.[4] The Court explained that the second requirement would be met for recovery of (1) medical expenses for injuries arising out of the accident, (2) the amounts for pain, suffering and emotional distress, and (3) the lost wages as long as the lost wages resulted from the time in which the taxpayer was out of work due to the injuries sustained in the accident.[5]
As the Congressional explanation to the 1996 amendment to § 104 (a)(2) provides, “if an action has its origin in a physical injury or physical sickness, then all damages (other than punitive damages) that flow therefrom are treated as payments received on account of physical injury or physical sickness whether or not the recipient of the damages is the injured party.”[6] For example, damages (other than punitive damages) received by an individual on account of a derivative claim for loss of consortium due to the physical injury or physical sickness of such individual’s spouse and damages (other than punitive damages) received on account of a claim of wrongful death are excludable from gross income.[7]
In their application of the income tax exclusion under IRC § 104 (a)(2), the courts have considered several factors to determine whether damages awarded are for personal injuries or sickness. Some of these factors have been the following: (1) the underlying complaint and the nature of the claims; (2) the settlement negotiations and settlement agreement; and (3) the intent of the payor.[8]
Emotional distress is not considered a physical injury or physical sickness.[9] Thus, for example, the exclusion from gross income does not apply to any damages received based on a claim of employment discrimination or injury to reputation accompanied by a claim of emotional distress.[10] However, because all damages received on account of physical injury or physical sickness are excludable from gross income, the exclusion from gross income applies to any damages received based on a claim of emotional distress that is attributable to a physical injury or physical sickness.[11]
Pre-judgment interest[12] and post-judgment interest[13] received on the award of damages on account of personal injuries or sickness are not excludable from gross income under IRC § 104 (a)(2) because they are not received on account of any physical injury or physical sickness.
IRC § 7701 (b) provides that an alien must be treated as a resident of the United States during any calendar year only if the individual either is lawfully admitted for permanent residence, or meets the substantial presence test under IRC § 7701 (b)(3), or makes an election under IRC § 7701 (b)(4). Under Treasury Regulation § 1.871-1, in general, resident alien individuals are taxable the same as citizens of the United States for income tax purposes. Therefore, a resident alien is taxable on income derived from all sources, including sources without the United States and can claim the same tax rates, exemptions, deductions, and credits using the same rules that apply to U.S. citizens. [14]
Any amounts received for personal injuries that are exempt from federal income tax are also exempt from New York State and local income tax.[15]
The decedent’s fiduciary may commence a personal injury action simultaneously with the wrongful death action. The personal injury action is considered decedent’s property[16] and it compensates him for medical expenses, pain and suffering, loss of earnings and other damages resulting from his injuries. Upon his death, the cause of action passes to his beneficiaries as a part of his estate, either under his will terms or under the intestacy laws.[17] In New York the decedent’s distributees, and their distributive share, are indentified in EPTL § 4-1.1. For instance, if the decedent is survived by a spouse and children (or the issue of predeceased children), the spouse and children are decedent’s distributees and the spouse takes the first $50,000 and ½ of the remaining estate and the children take the other ½ of the remaining estate, by representation.[18]
The amounts that a decedent’s estate[19] or beneficiaries[20] receive after the decedent’s death are excludable from income tax under IRC § 104 (a)(2).
The personal injury cause of action is also part of the decedent’s gross estate for estate tax purposes at the federal and NY State levels[21] and subject to his creditors’ claims.[22]
On the other hand, the wrongful death cause of action is not part of the decedent’s estate because it belongs to the decedent’s distributees[23] who suffer a pecuniary loss because of his death, regardless of how or whether the decedent disposed of his property by will.[24] If the decedent had no distributees, there is no cause of action for wrongful death.[25]
The wrongful death recovery is also excluded from the decedent’s gross estate for estate tax purposes.[26]
EPTL §5-4.4(a)(1) specifies that wrongful death proceeds must be distributed to the decedent’s distributees “in proportion to the pecuniary injuries suffered by them, such proportions to be determined … in such manner as the court may direct.”
Whether or not a federal and/or a NY State estate tax return has to be filed with the tax authorities depends on the value of the decedent’s gross estate, and federal adjusted taxable gifts, specific exemption, and the amounts of the applicable estate tax exclusion at the federal and NY State levels in the year of decedent’s death.
For instance, for U.S. citizens and for foreign nationals domiciled in the U.S., who died in the year 2004, a federal estate tax return, Form 706, must be filed if the gross estate, plus adjusted taxable gifts and specific exemption, exceeds the applicable exclusion amount of $1,500,000, even if no tax is due. [27] Similarly, the estate of an individual who died on or after January 1, 2004 and who was either a resident or U.S. citizen at the time of death, must file a NY State estate tax return if the estate includes real or tangible personal property having an actual situs in NY and the gross estate, plus federal adjusted taxable gifts and specific exemption, exceeds $1,000,000.[28]
An unlimited marital deduction generally is allowed for federal estate and gift tax purposes for the value of property passing to a spouse.[29] New York State also applies this unlimited marital deduction for estate tax purposes whenever it is available at the federal level.
However, the marital deduction is generally disallowed for the value of property passing to a noncitizen spouse. Property passing at death to a noncitizen spouse may qualify for the marital deduction so long as it satisfies the requirements of IRC § 2056 (b) and passes in a qualified domestic trust (“QDOT”). This requirement insures that on such spouse’s death (or on lifetime principal distributions) transfer taxes are paid.[30] Property passing to the spouse outside the probate estate is treated as passing in a QDOT if it is transferred to such trust before the estate tax return is filed. That is the QDOT may be created by the executor, administrator, or the surviving spouse.
To be a QDOT, a trust must meet, in general, the following four conditions:
1) The trust instrument must require that all trustees be U.S. citizens or domestic corporations.
2) The surviving spouse must be entitled to all the income from the property in the trust, payable annually or at more frequent intervals. No principal distribution may be made unless the U.S. trustee has the right to withhold the tax imposed by IRC § 2056A.
3) The trust must meet the requirements of Treasury regulations provided to ensure collection of the estate tax imposed upon the trust.
4) Finally, the executor or administrator must elect to treat the trust as a QDOT.
In New York the estate’s fiduciary is personally liable for the NYS estate tax to the extent estate assets have been paid or distributed, but the tax remains unpaid. The fiduciary shall charge the tax against and collect it from the persons interested in the estate in accordance with the rules of apportionment contained in N.Y. Est. Powers & Trusts Law (“EPTL”) § 2-1.8 and other relevant sections of the EPTL. If any property of the decedent’s gross estate passes to his spouse or a charity, and the unlimited marital and charitable contribution deductions under IRC §§ 2056 and 2055, respectively, are applicable, then those beneficiaries do not share in the tax burden.[31]
IV. Conclusions
A. Issue 1
The amounts that the decedent’s estate, and eventually his beneficiaries, may receive on account of the decedent’s physical injuries that lead to his pain and suffering are excluded from gross income under IRC § 104 (a)(2).
Any amounts that decedent’s estate may receive from a personal injury cause of action will be excluded from New York State and local income tax.
However, any pre-judgment interest and post-judgment interest received as part of the award of damages is not excludable from gross income under IRC § 104 (a)(2).
B. Issue 2
The amount that the decedent’s distributees, including his resident alien spouse, may receive from their wrongful death cause of action for their pecuniary losses is also excluded from their gross income under IRC § 104 (a)(2).
Any amounts that decedent’s distributees may receive from a wrongful cause of action will be excluded from New York State and local income tax.
However, any pre-judgment interest and post-judgment interest received as part of the award of damages is not excludable from gross income under IRC § 104 (a)(2).
C. Issue 3
The amounts that the decedent’s estate may receive on account of the decedent’s pain and suffering are included in the decedent’s gross estate at the federal and NY State levels.
D. Issue 4
The amounts that the decedent’s distributees may receive from their wrongful death cause of action are not part of decedent’s gross estate at the federal and NY State levels.
E. Issue 5
Whether or not a federal and/or NY State estate tax returns have to be filed depends on the value of the decedent’s gross estate, federal adjusted taxable gifts, and specific exemption.
Based on the unverified information that C.P.A. provided in the drafts of IRS Form 706 and NYS ET-706, I can only make hypothetical statements about how much approximately could be allocated to the award damages on account of pain and suffering that will either not require a filing of a federal and/or NY State estate tax returns or require their filings. If their filings are required, since the decedent’s surviving spouse is a resident alien and there is no QDOT yet in place, the unlimited federal and NY State marital deduction will not apply to any amount that may be distributed to her from the decedent’s estate. Therefore, the amount of a tax liability, if any, due in the filed federal and NYS estate tax returns depend on the actual amount actually allocated to the pain and suffering cause of action, which at this point is uncertain.
Based on the information that C.P.A., the decedent did not make any adjusted taxable gifts and the specific exemption does not apply. Thus, based on the preliminary information that he has provided regarding the amount of assets included in the decedent’s gross estate in addition to the proceeds from any pain and suffering cause of action, the approximate maximum amount that could be allocated to pain and suffering in the federal tax return that would not require its filing is $933,064, which will result in a gross estate of $1,500,000.[32] However, the approximate maximum amount that could be allocated to pain and suffering in the NYS estate tax return that would not require its filing is $433,064, which will result in a gross estate of $1,000,000.
The specific amount that would pass to the surviving spouse and thus, stated in Schedule M of the federal tax return depends on the allocation of the pain and suffering amount (e.g. $933,064) attributed to the spouse by either the application of NY statutory distribution rules or by court settlement agreement, whichever applies.
If in this case, where no unlimited marital deduction is currently applicable, a NYS estate tax return with a gross estate of $1,500,000 is filed, the approximate NYS estate tax liability would be $57,119.36.
F. Issue 6
The marital deduction is generally disallowed for the value of property passing to a noncitizen spouse such as the decedent’s surviving spouse. The percentage portion of the pain and suffering damages included in the decedent’s gross estate, which passes to her may qualify for the marital deduction so long as it satisfies the requirements of IRC § 2056 (b) and passes in a qualified domestic trust (“QDOT”).
G. Issue 7
The most beneficial allocation to the surviving spouse of the amounts that she may receive from the decedent’s estate for the estate’s cause of action for the decedent’s pain and suffering and the amounts that she may receive as a distributee from the distributees’ cause of action for decedent’s wrongful death depends on several factors such as, but not limited to, whether or not the unlimited marital deduction will be applicable at the moment of the transfer of any portion of the pain and suffering proceeds, whether or not the NY intestacy statute will govern the distribution of the decedent’s assets including the proceeds for his pain and suffering, the existence of creditor’s claims, and what proportion of the pecuniary injuries from the wrongful death cause of action the court determines that she actually suffered as compared to the other distributees.
Based on my very limited knowledge of the courts’ actual process for the allocation of the pecuniary losses in wrongful death actions, and as my discussion of the current tax laws above indicates, any proceeds from the wrongful death cause of action that are allocated to the surviving spouse will be excludable form her income tax, will not lead to any decedent’s estate tax consequences, and will be distributed directly to her. However, the amounts that the surviving spouse receives from the decedent’s estate may be subject to the NY statutory instestacy distribution rules, might lead potentially to estate tax consequences, and might lead potentially to the application of the NY tax apportionment rules for the payment of any tax liability due.
[1] See Commissioner v. Schleier, 515 U.S. 323, 328 (1995).
[2] Amendments to IRC § 104(a)(2) were enacted in 1996. Any references in this writing to IRC § 104(a)(2) is to post-1996 law.
[3] Treas. Reg. § 1.104-1(c).
[4] See Schleier at 329.
[5] See id.
[6] H.R. Conf. Rep. No. 104-737, at 301 (1996) (United States Code, Congressional and Administrative News, 104th Congess-Second Session, 1996, Vol. 5, Legislative History, Public Laws 104-185 to 104-201); See also P.L.R. 199952080 (the Service ruled that the damages a couple received for lost wages and unpaid medical bills, pain and suffering, and loss of consortium in a personal injury action against the husband’s emplower are excludable from gross income under IRC § 104 (a)(2)). Under IRC § 6110(k)(3), a private letter ruling may not be used or cited as precedent, and is binding only on the taxpayer to whom it is issued. Nevertheless, private letter rulings provide insight into the Internal Revenue Service’s position.
[7] See H.R. Conf. Rep. No. 104-737, at 301.
[8] See T.C. Memo 2002-134; United States v. Burke, 504 U.S. 229, 239 (1992); Thompson v. Commissioner, 866 F.2d 709, 711 (4th Cir. 1989), affg. 89 T.C. 632 (1987); Agar v. Commissioner, 290 F.2d 283, 284 (2d Cir. 1961), affg. per curiam T.C. Memo. 1960-21; Knuckles v. Commissioner, 349 F. 2d 610, 612-613 (10th Cir. 1965).
[9] H.R. Conf. Rep. No. 104-737, at 301 (1996) (it is intended that the term emotional distress includes physical symptoms such as insomnia, headaches, stomach disorders, which may result from such emotional distress).
[10] See id. See also Marrita Murphy et al. v. IRS et al., No. 05-5139, (D.D.Cir. July 3, 2007) (Doc 2007-15777), where the United States Court of Appeals for the District of Columbia Circuit, after vacating its prior holding, has affirmed a district court and held that an individual’s compensatory damage award for emotional distress and loss of reputation is gross income, it is not excludable from gross income under IRC § 104(a)(2) because it was not received from physical injuries, and a tax on the award is not an impersmissible direct tax. Recently the D.C. Court of Appeals denied Marrita Murphy’s request for a rehearing by the full court of the second Murphy v. IRS ruling. See Marrita Murphy et al. v. IRS et al., No. 05-5139, (D.D.Cir. Sept. 14, 2007) (Doc 2007-21206).
[11] See H.R. Conf. Rep. No. 104-737, at 301.
[12] T.C. Memo 2001-245.
[13] P.L.R. 199952080.
[14] See Internal Revenue Service’s website at www.irs.gov under the subject of Taxation of Resident Aliens; See also IRS Pub. 519 U.S. Tax Guide for Aliens (resident and nonresident aliens are allowed exclusions from gross income if they meet certain conditions).
[15] N.Y. Tax Law § 612; See also New York State Department of Taxation and Finance’s Advisory Opinion TSB-A-92 (12) I (December 15, 1992); New York State Department of Taxation and Finance’s Advisory Opinion TSB-A-82 (8) I (October 15, 1985) (New York Tax Law § 612(a) provides that gross income of a resident individual, the starting point in determining New York taxable income, means Federal adjusted gross income, with certain modifications; inasmuch as New York Tax Law § 612 does not provide for a modification based on the receipt of payments excluded from Federal gross income, and therefore Federal adjusted gross income, pursuant to IRC § 104 (a), such amounts are not required to be added to Federal adjusted gross income in determining New York adjusted gross income).
[16] N.Y. Est. Powers & Trusts Law (“E.P.T.L.”), § 11-3.3(a); Margaret Valentine Turano & C. Raymond Radigan, New York Estate Administration § 20.01 (2006 Edition).
[17] See id.
[18] EPTL § 1-2.16 provides that the term “by representation” means that the property is divided into as many equal shares as there are (i) surviving issue in the generation nearest to the deceased ancestor which contains one or more surviving issue, and (ii) deceased issue in the same generation who left surviving issue. Each surviving member in the nearest generation is allocated one share. The remaining shares (if there are deceased issue who left issue) are combined and then divided in the same manner among the surviving issue of the decased issue as if the suriviving issue who actually took a share had predeceased the decedent without issue.
[19] Rev. Rul. 79-220, 1979-2 C.B. 74.
[20] P.L.R. 9812027 (December 18, 1997).
[21] I.R.C. § 2033; Matter of Franco, 108 Misc. 2d 1084, 439 N.Y.S.2d 278 (Sur. Ct. Bronx County 1981) (tax commission must be given notice of allocation hearing).
[22] See Turano; Matter of Franco (pain and suffering portion of recovery is available for creditors’ claims, while the wrongful death portion is not).
[23] Baer v. Broder, 436 N.Y.S.2d 693, 696 (1981); George v. Mt. Sinai Hosp., 417 N.Y.S.2d 231, 235 (1979); Central New York Coach Lines v. Syracuse Herald Co., 13 N.E.2d 598, 599 (1938) (a cause of action for wrongful death is not an asset of decedent’s estate, but rather a property right of distributees); N.Y. Est. Powers & Trusts Law (“E.P.T.L.”), §§5-4.1, 5-4.4.
[24] See Turano.
[25] See id.
[26] See I.R.C. § 2033; Turano; Connecticut Bank and Trust Co. v. United states, 465 F.2d 760 (2d Cir. 1972) (wrongful death proceeds excludible even in those states where the wrongufl death action is, unlike in New York , a survival action).
[27] I.R.C. § 6018(a)(1); Intructions for Form 706 (United States Estate and Generation-Skipping Transfer) Tax Return).
[28] Instructions for Form ET-706 (New York State Estate Tax Return).
[29] I.R.C. §§ 2056 (a) and 2523 (a).
[30] I.R.C. § 2056A.
[31] EPTL § 2-1.8 (c)(2).
[32] Please note that C.P.A. allocated approximately 75.9% of the pain and suffering amount of $830,720 listed in schedule F of the federal estate tax return to the amount transferred to surviving spouse and stated in shedule M of this return (i.e., $630,720).
