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Satisfying Personal Injury Judgment with Settlement Proceeds from a Bad Faith Claim

Compensation for a victim’s injuries in a personal injury accident is typically made by an insurance company.  In California, insurance companies owe three duties to the person whom they have insured (the “policyholder”): (1) duty to defend a claim (or lawsuit) even if some or most of the lawsuit is not covered by the policy; (2) duty of indemnification, which is the duty to pay a judgment against the policyholder up to the coverage limit; and (3) duty to settle a reasonably clear claim against the policyholder within policy limits.  When an insurance carrier violates one of these duties, the policyholder can bring a cause of action against the insurance company for bad faith.

When an insurance company refuses to settle a claim under the policy limits, the policyholder may have a claim against the insurance company for bad faith.   If the victim is awarded a judgment against the policyholder in excess of the policy limit, the policyholder can assign or transfer his claim for bad faith to the victim in satisfaction of the judgment.  This assignment or agreement to transfer will specify that any proceeds from the bad faith claim satisfy any liability owed to the victim by the policyholder under the judgment.

When a personal injury claim is satisfied in this way the question becomes: What are the tax consequences to (1) the victim and (2) the policyholder?

Tax Consequences to the Victim

Private Letter Ruling 200903073 involved a highway construction worker who was hit and rendered quadriplegic by a drunk driver.  The driver, a tavern manager, became intoxicated while on duty. The injured party brought a tort action and was awarded compensatory and punitive damages. Prior to the judgment award, the tavern’s liability insurance carrier rejected an opportunity for settlement. The tavern filed a suit against the insurance company for failure, in bad-faith, to settle the claim.

The tavern then transferred the bad faith claim against the insurance company by assignment agreement in order to stay execution of the victim’s judgment against the assets of the driver and the tavern.  The injured party agreed that upon settlement with the insurance company, the judgment would be satisfied and all remaining litigation dismissed.  Following the end of the suit, the question of whether the settlement proceeds were taxable came up.  The IRS concluded that because the transfer of the bad faith claim was in satisfaction of a claim originating in personal injury, it would not be included in gross income pursuant to IRC §104(a)(2).  Any amounts received to settle claims other than for physical injury and sickness, such as punitive or other damages, would be includible in the injured party’s income under IRC §61.  The PLR discusses the fact that this exclusion from gross income applies only to the degree the proceeds cover the settlement of non-punitive, personal injury damages.

Tax Consequences to the Policyholder/Defendant

The tax consequences to the policyholder who was the defendant in the personal injury action is a more complicated question.  Since there is no direct authority on this point, an analogous case would be presented by the following facts:

Assume that a policyholder/defendant is sued, the insurance company refuses to settle within policy limits and a judgment is realized in excess of the policy limits.  The policyholder/defendant pays the judgment and then sues the insurance company for bad faith and recovers.  Is the recovery taxable?  If the policyholder merely sued the insurance company for bad faith based on the fact that the company failed to settle with the victim for the limits of the policy and the policyholder collected the award, what would be the tax consequences to the policyholder upon receipt?

It is important to first note that the policyholder is not a physically injured party and has not received the award for personal injuries, so the income from the award will not be shielded by IRC §104.  Therefore, the next logical step is to look at the nature of the recovery under the “origin of claims” doctrine, which would be damages for breach of contract and would be considered taxable income.  The question that immediately follows would be whether the payment of the judgment by the policyholder/defendant would be deductible.  Assuming that the injury did not result in a business or investment context, the only basis for deductibility would be a casualty loss.  Internal Revenue Code §165(c)(3) allows noncorporate taxpayers a deduction for losses arising from fire, storm, shipwreck, or other casualty, or from theft, incurred with respect to property that is neither used in a trade or business nor held in a transaction entered into for profit.  It is unlikely that the payment of a judgment for personal injury will be considered “with respect to property” and therefore would not be deductible as a casualty loss.  The other possibility is to consider the award for the bad faith action simply as a reimbursement of an otherwise nondeductible loss.

A similar line of cases to claims of bad faith against insurance carriers has developed with respect to awards in malpractice cases.  A seminal case in this area is Clark v. Commissioner, 40 B.T.A. 333 (1939).  The Board of Tax Appeals determined that an amount received from tax counsel as compensation for an error in preparing and filing the plaintiff’s tax return was not includible in the plaintiff’s gross income.  The reasoning behind this finding was based on the fact that the taxpayers had paid $20,000 in extra tax based upon the preparer’s error.  But for this error, the taxpayers would not have had to pay that amount, and the $20,000 paid by the preparer to settle the case merely reimbursed the taxpayer for the erroneous taxes paid.   In application to the question at hand, if the insurance company had settled with the victim for the policy limit, the policyholder would not have had to make any payment to the victim for his injuries.

Another malpractice case that follows this line of reasoning is Revenue Ruling 57-47.  This ruling goes farther than Clark, addressing the issue of a settlement/award amount in excess of the actual loss experienced by the taxpayer.  In this case, a tax consultant’s error caused the taxpayer to pay additional tax.  In settlement, the tax consultant reimbursed the taxpayer for the additional tax plus interest on that amount.  The IRS found that the amount in excess of the tax paid by the taxpayer was income to the taxpayer, not a reimbursement of the loss on account of the tax consultant’s error.

The same line of reasoning should apply to the policyholder in a bad faith claim against his insurance carrier.  If the insurance company refuses to settle a claim at the policy limit and as a result, the policyholder has a judgment entered against him in excess of the policy limit, the policyholder will be required to pay this excess amount.  If the policyholder makes this payment and is later reimbursed for this payment through a bad faith action against the insurance company, there are no tax consequences to the policyholder.

If the insurance company had settled within the limits of the policy, the policyholder would not have been responsible for payment of this amount in excess of the policy limit.  Thus, an award from a bad faith claim against the insurance company should only be income to the extent it exceeds the amount that the policyholder was required to pay out of his own pocket on account of the insurance company’s failure to settle for the policy limit.  Any excess award from the bad faith claim will be considered income to the policyholder because it is not merely compensating the policyholder for the additional amount he was required to pay.

Tax Consequences of Transfer/Assignment of Settlement/Judgment Award from Bad Faith Claim

Combining the above discussions, we now analyze the tax consequences to the policyholder when he assigns his bad faith claim in satisfaction of the victim’s judgment against him.

As discussed above, the only situation that might create income tax consequences to the policyholder would be if the bad faith claim award is in excess of the amount that the policyholder is required to pay to the victim out of his own pocket.  This is because the policyholder is merely being reimbursed for its expenses resulting from the bad faith of the insurance company.  Any excess payment is not a reimbursement, but income to the policyholder.

When the policyholder assigns his bad faith claim to the victim in full satisfaction of the victim’s judgment against him, there is an argument that no part of the proceeds of this award is taxable to the policyholder.   In absence of the insurance company’s bad faith and breach of duty to settle, the policyholder would not be liable for any judgment.  Therefore, any amount paid to the victim in satisfaction of the judgment should be considered reimbursement for the judgment against the policyholder, whether or not it exceeds the actual amount of the judgment.  Because the amount transferred or assigned from the claim would not have arisen without the insurance company’s bad faith, it should be nontaxable to the policyholder.

As a practical argument, the policyholder will have no benefit or use of the funds that are in excess of the actual judgment amount.  In fact, that amount will not likely be distributed into the policyholder’s bank account because it will go directly to the victim in satisfaction of his claim.  This supports the nontaxable character of any proceeds transferred or assigned to the victim.

Conclusion

If a bad faith claim is not transferred or assigned, any award recovered that is excess of the actual out of pocket amount the policyholder was required to pay will be considered income to the policyholder.  This is because it is not in reimbursement of amounts paid by the policyholder and caused by the insurance company’s bad faith.

When a claim against an insurance company by a policyholder is transferred or assigned to a victim with a judgment against the policyholder, there should not be any tax consequences to the policyholder, based on the fact that absent the bad faith of the insurance company, there would not have been a judgment against the policyholder.  Thus, any amounts transferred with respect to the bad faith claim would be a reimbursement to the policyholder.

Once the funds are received by the victim, there may be tax consequences if the award is in excess of amounts paying for physical injury and sickness, which is expressly excluded under §104(a)(2).  Any amounts received for punitive or other damages will be included in the injured party’s income under §61.

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