Are insurance bad faith litigation recoveries taxable? The annoying answer is that it depends. This answer may be a bit less annoying with a brief description of what a bad faith claim may entail. It may be a tort or a contract claim, depending on the facts and the jurisdiction. It may be brought against one’s own insurance carrier, or sometimes, even against someone else’s carrier.
A common claim is that the insurance company defendant did not proceed appropriately to pay a claim, thus causing the plaintiff additional damages. In that sense, not unlike a legal malpractice claim against a lawyer, one key question will predate the bad faith case: what was the underlying issue (which may or may not have been litigated) that gave rise to the insurance claim? Most tax professionals will start to imagine a physical injury accident where the insurance company pays too little too late, and later must pay more for the same injuries via a bad faith claim. That is a useful (and common) example to bear in mind.
2009 IRS Ruling
The most important authority is a 2009 IRS private letter ruling (although technically letter rulings are non-precedential and not authority). It was a bombshell ruling when it was issued, and it suggests that some bad faith recoveries are tax free. Some case law, on the other hand, suggests that some taxpayers may be reading the ruling too broadly.
In Letter Ruling 200903073, a plaintiff had been employed as a construction worker, and in the course of his employment, was struck by a drunk driver. The drunk driver managed a tavern and had served himself liberally while on duty. The plaintiff was severely injured, and sued the driver/manager as well the tavern that had employed him.
The plaintiff received a jury verdict consisting of compensatory damages for his personal physical injuries, medical expenses, pain and suffering, lost earnings, plus punitive damages. After post-trial motions, the jury verdict was reduced to $X in compensatory damages and $Y in punitive damages. The defendants appealed.
Prior to the judgment, the insurer for the tavern (Insurance Company) had rejected an opportunity to settle for policy limits under the tavern’s policy. Under state law, the tavern as policy holder had a cause of action against Insurance Company if it acted in bad faith in failing to settle the claim. The tavern believed it had a bad faith cause of action against Insurance Company. Accordingly, the tavern entered into an agreement with the plaintiff to stay the execution of the plaintiff’s judgment and to assign to the plaintiff all claims possessed by the tavern and the tavern manager against Insurance Company related to bad faith. The assignment agreement also provided that within 30 days of the termination of the litigation against Insurance Company (whether by settlement or judgment), the judgment against the manager and the tavern (relating to plaintiff’s personal injury claims) would be marked “satisfied.”
Eventually, the plaintiff entered into a settlement agreement calling for the insurance company to pay $Z to plaintiff and his attorneys. The settlement agreement provided that upon receipt of payment, plaintiff would cause the bad faith insurance litigation to be dismissed with prejudice, and cause the personal injury judgment against the tavern manager and the tavern to be marked as satisfied.
Underlying Case Tax Free
The IRS starts its analysis in the Letter Ruling with the “origin of the claim” doctrine. Citing Raytheon Production Corp. v. Comm’r, the Service states that the critical inquiry here is in lieu of what were the damages awarded. The plaintiff may have recovered against Insurance Company, but the recovery had its origin in the settlement of the court cases against the tavern manager and the tavern. Indeed, the plaintiff was merely trying to collect on the plaintiff’s judgment against the manager and the tavern for damages awarded on his personal physical injury claim. “But for” the personal physical injury claim and the plaintiff’s rights as an assignee, the plaintiff would be receiving nothing from the insurer for the tavern. Quite literally, the plaintiff was only receiving money from Insurance Company because the plaintiff was injured.
Thus, the Service concluded that the section 104 exclusion applied. Interestingly, the Service noted that the exclusion would not apply to any amounts the plaintiff received that resulted from the punitive claims. Punitive damages are always taxable. Letter Ruling 200903073 expresses no opinion on allocating between compensatory and punitive damages.
Contract vs. Tort?
In bad faith insurance cases, there is an underlying cause of action for which the taxpayer is seeking redress. It might be a personal physical injury action or something else. It may be viewed as a contract claim relating to the insurance policy, or as a tort claim related to the insurance company’s operations and its treatment of the plaintiff.
The IRS has usually viewed them as contract actions. Regardless, it is relevant to inquire into the treatment of damages that, at least in part, often relate to the original act producing the underlying insurance claim. Not surprisingly, most bad faith insurance cases relate to the mishandling of insurance claims.
Recent Cases
Perhaps as a result of the 2009 letter ruling, some taxpayers may think “tax free” when they hear “bad faith.” For example, in Ktsanes v. Comm’r (a summary opinion and therefore also non-precedential), the taxpayer worked for the Coast Community College District (“CCCD”) in Orange County, California. In connection with his employment, Ktsanes participated in a group long-term disability insurance program managed by Union Security.
The premiums were paid by Ktsanes’s employer, CCCD, and were not included in Ktsanes’s income. Ktsanes developed Bell’s palsy, which caused him to be unable to continue working for CCCD. He filed a claim for long-term disability with Union Security, which the insurance company denied, saying that Ktsanes was not sufficiently disabled to qualify.
Ktsanes filed a bad faith claim against Union Security. The claim was settled for $65,000. Ktsanes claimed the settlement payment was received on account of a physical sickness (the Bell’s palsy), and therefore excluded it from his gross income under section 104(a)(2). When the IRS disagreed, Ktsanes also argued that the group long-term disability insurance program was equivalent to a workmen’s compensation payment, so was excludable under section 104(a)(1).
The Tax Court rejected both arguments and found the settlement to be taxable. The Tax Court concluded that Ktsanes’s damages were received “on account of” the insurance company’s refusal to pay the insurance claim and not the Bell’s palsy that gave rise to the insurance claim. The court reasoned:
The relief that petitioner sought in his complaint was causally connected (and strongly so) to the denial by Union Security of his claim for long-term disability benefits. Although petitioner’s complaint alleged that he became disabled as a result of physical injuries or sickness, this “but for” connection is insufficient to satisfy the “on account of” relationship discussed in O’Gilvie for the purposes of the exclusion under section 104(a)(2). Petitioner would not have filed his complaint if Union Security had not denied his claim but instead paid him the long-term disability payments that he sought. In other words, petitioner sought compensation “on account of” the denial of his long-term disability benefits, not for any physical injuries or physical sickness.
On the surface, this reasoning might make it difficult for bad faith recoveries to qualify under section 104(a)(2). Indeed, when taxpayers claim that bad faith recoveries are excludable from gross income under section 104(a)(2), the personal physical injury or physical sickness almost always concerns the facts that gave rise to the insurance claim, rather than the denial of the claim itself. Put differently, relatively few bad faith claimants can assert that the insurance company actually caused them physical harm.
Nevertheless, some plaintiffs can claim that insurance company delays exacerbated their physical injuries and physical sickness. In that kind of case, the argument for excluding all or part of the eventual bad faith recovery can be strong. In Ktsanes, though, the Tax Court concludes the opinion in a way that cuts off that possibility.
The $65,000 that [Ktsanes] received in settlement of his suit essentially represented a substitute for what he would have received had his claim been approved. Under these circumstances, no part of that payment is excludable under any subdivision of IRC § 104(a).
This language, emphasized by its placement at the very end of the opinion, seems to contradict the court’s previous language. It looks through the insurance claim to the facts that gave rise to the insurance claim. Moreover, it implicitly asks how the payment would have been taxed had the insurance claim been paid without dispute. The taxation of an undisputed payment would surely depend on the facts that gave rise to the insurance claim.
In Ktsanes, the court seems bothered by section 104(a)(3). Notably, Ktsanes did not raise this sub-section as a basis for excluding the settlement payment from his income. Under section 104(a)(3), amounts received through accident or health insurance for personal injuries or sickness are excludable from gross income. The key qualifier, of course, is that the premiums for the insurance must not have been paid by the insured’s employer as a tax-free benefit to the insured. Ktsanes’s long-term disability premiums were paid by his employer and were not included in his income. Thus, he clearly did not qualify for tax-free treatment under section 104(a)(3). Had his insurance claim been paid without dispute, it would presumably have been taxable.
