 Hello and welcome to the session in which we would look at the taxability or lack of for compensation for injuries and sickness. What does that mean? It means when an individual receives some sort of a compensation for damages. Is that amount taxable or not? Well, it all depends. The tax implication for receiving damages vary depending on the harm suffered by the taxpayer. So when the individual pursues compensation, they may receive damages for various reasons. What could be those reasons? Why would you want to receive damages? It is possible that you could have lost some income. You lost your source of income. You could have incurred expenses. You could have had some property damage or you could receive compensation for personal injury. So is it taxable or not taxable? It all depends on the type of the specific harm you suffered and what are you trying to get compensated for. This is what we will discuss in this session. Before we proceed any further, I have a public announcement about my company Farhat Lectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions as well as exercises. Go ahead, start your free trial today. Starting with loss of income. As the title suggests, somehow you are losing income. Well, if that's the case, loss of income, of what? Because you were working, now you could not work. You're not producing. Well, if that's the case, you are replacing your income. Well, your income would have been taxable. This amount would be taxable as well. Loss of income is typically subject to taxation in similar way as the income it replaces because it's you are substituting your income. Well, your income would have been taxed. This income is taxed as well. However, there are certain exceptions to this rule, particularly when it comes to personal injury, which we'll see more about personal injury in this session. But loss of income, generally speaking, is taxable. Something what happened is you incur expenses. And if you incur expenses, you might ask for compensation for those expenses. Are they taxable or not, when you get this compensation? Well, it all depends. If you deducted the expense, if the expense was deducted, the recovery of that expense is taxable. If it's not deducted, then the expense is not considered an income. What does that mean? It means if in year one you took an expense and you took an expense, you incurred an expense, and you deducted this expense. This is in year one. In year two, if you got the income, well, if you deducted the expense, then it's income. Well, if you did not deduct the expense and they replaced your, they reimbursed you for their expense, then it's not income. So if the expense was previously deducted, the damage is received, the second topic is incurred expenses. Sometime what happened is you incurred expenses, and as a result, you might get compensated for those expenses. If the expense was not deducted, the recovery of that expense is not considered an income. So simply put, if the expense was not deducted in the prior year, in the prior period, you did not took advantage of that and took a tax deduction. When you received it, it's not considered income. If the expense was previously deducted, so if you were able to deduct this expense, in other words, you took a tax deduction, the damage generally received are generally subject to taxation. Well, if you took the deduction, you took advantage of that expense. Now you are being reimbursed, the damages received are subject to taxation. And this is basically, it's going to take us to a separate topic, which is called the tax benefit rule. So if you were able to take advantage of the expense and the expense was reimbursed to you, well, the tax benefit rules will kick in. This is basically how it works, but we're going to work more specific examples. It's a one topic by itself, the tax benefit rule, but the incurred expense falls under this category. Sometime what happened is you sue, you want to be compensated because the property, your property was damaged, could be a car, a building, so on and so forth. When that happened, when the property is damaged, any payment received is considered as if you sold the property or exchanged the property. Now what happened when you sold the property or exchanged the property? Well, if the amount received, which is consideration received, is greater, greater exceeds the basis, you have a gain. So if the money that you received is greater than the basis of the property damaged, you have a gain. Now if it's a personal property, you can't take the deduction because if you sold it, you can't take the deduction as well. Let's talk about personal injury. Here we're going to have to expand a little bit more on personal injury. The big idea behind personal injury is to provide the injured party with that amount that restored them to their pre-injury state. So let's assume an individual fall off this step. Well, guess what? They broke their ankle, they broke their leg, their hand, whatever happens is now you want to compensate them to a state, the pre-injury state. This is the whole idea about the personal injury damage. This means if the damage were taxable, this means if the damages received were taxable, then the after-tax amount will be less than the actual damage is severed. So if you gave someone a thousand dollar and that amount is taxable, let's assume their tax rate is 20%, simply put this individual would only receive 800 as net. So resulting, resulting in an injury party not being fully compensated. Therefore, you have to compensate them for more so it net out to be a thousand dollar if that's what you want to give them. But when it comes to personal injury, remember we're going to differentiate between two types and this is important. We have personal injury that's considered compensatory damages and personal injury that's punitive damages, those two. Let's talk about each one separately. Starting with personal injury compensatory damages. Well, this aims to provide compensation for the harm suffered by the taxpayer. For example, you hurt your back. Only compensatory damage received for physical personal injury or physical sickness like a back problem can be excluded from the gross income because it's a physical. So this includes the loss of income related to the physical personal injury or the physical sickness. Remember we talked about the loss of income. That's fine. However, compensatory damages awarded for emotional distress. This is not physical distress. Emotional cannot be excluded from gross income. It means it's taxable unless the amount received is for medical care. So you receive the amount and you paid it for medical care for emotional distress. That's fine. You're not going to be taxed for that. Also, any amount received for age discrimination or damages to one's reputation cannot be excluded. It's included because it's not physical personal injury or physical sickness. So compensatory damages for physical personal injury and physical sickness are excluded. How about you are suing for punitive damages? What's punitive damages? Is you want to penalize the other party. Punitive damages are monetary award money. You're asking them for money that the responsible party must pay as a form of punishment. You are penalized them for their misconduct. Now this is different. Unlike compensatory damages which is aimed to compensate the victim, punitive damages are intended to penalize the wrongdoer. So receiving punitive damages may actually put the injured position in a better financial situation than before. Well, what do we need to about taxation? It's subject to taxation. So due to the purpose and effect punitive damages are considered part of gross income. So punitive damages are taxable unless it's a wrongful incarceration. What is wrongful incarceration? Well, if you're interested in this topic, I'm going to advise you watch on Netflix a show called The Innocence File. Basically, some people, they might be sent to jail, they might be found guilty by mistake. And what happened is after the DNA technology became a very prevalent technology, what they did, they revisited many evidence and what they find out, the DNA of the imprisoned person was not found in the crime scene. What does that mean? It means that person wasn't there but that person was convicted in a court of law. So what they did is they released that individual because they were innocent. They could not find their DNA. So damages received as compensation for wrongful incarceration are exempt from taxation. And some people, if you watch the show, they were spent 20, 25 years in prison, wrongfully imprisoned. Then at the end of the day, they found out they were innocent. Well, guess what? Here, they're not going to pay taxes on that if they receive damages. This execution applies to individual who have been convicted of a federal or state crime and subsequently exonerated. It means they became innocent. In other words, if someone was wrongfully imprisoned and later found innocent, this is what we're talking about here, any financial compensation they receive for the wrongful incarceration as subject to income tax. And this is simply fair, if not more than fair, right? Because you took basically their life and now you're telling them, you know, sorry, we made a mistake. So the amount they receive is not taxable. Let's talk about workers' compensation. What is workers' compensation? It's a system that provides financial benefits and medical care to employees who have suffered work-related injuries or sickness. Simply put, as a result of working on the job, you suffered some sort of an illness or an injury. The employer will have insurance. That's called workers' compensation insurance. It's a form of insurance that employers are legally required to have in place to do what? To protect their workers. Now, here's what's odd about workers' compensation. Payments made to employees are considered lost wages. In generally speaking, when it's lost wages, we assume it's taxable. However, workers' compensation are not considered taxable income. Simply put, what you need to know about workers' compensation, they are executing. By executing those compensation, basically what the tax code or what the government is trying to do is to prevent the injured workers from being burdened with additional tax liabilities during this challenging time. Sometimes your injuries could be very, very serious. Simply put, to compensate them for the financial hardship caused by work-related injuries or illness. All in all, workers' compensation, you see this, not taxable. Let's take a look at a few examples to illustrate the concepts. Emily received $200,000 in settlement of a sex discrimination against her formal employer. Well, is this a physical injury? And the answer is not. Sex discrimination is not a physical injury. It's a non-physical. Therefore, it's included in income. Nora received $8,000 for damages to her personal reputation. Okay, it's personal reputation, physical injury. Now, additionally, she received $35,000 in punitive damages. Are punitive damages taxable? Yes, the $8,000 and the $35,000 are taxable. Blue Corporation, an accrual taxpayer, received $40,000 from a lawsuit filed against its auditor who overcharged for services rendered in the prior year. So what did we do? We were overcharged the prior year. We paid $40,000 in prior year. What we're trying to do is getting basically reimbursed, assuming the $40,000 was deductible in the prior year because we're trying to recover it. Then the amount is taxable. So if we took it, if we took this $40,000 as a deduction, then we assumed we took it as a deduction. Therefore, it's taxable now. Lily received $12,000 compensatory damages and $25,000 in punitive damages and a lawsuit she filed against a beauty salon for severe burns she received from using its standing equipment. Well, what would you say? I would say the punitive we already know, the punitive are included. They are taxable. What about the $12,000? The $12,000 is for physical injury, severe burns. I would say they are physical injury. Therefore, the $12,000 is not included, but the punitive damages are included. Elise received compensatory damages of $90,000 for punitive. Already we know this is going to be taxable punitive damages and $250,000 for a plastic surgeon who mishandled her rhinoplasty surgery. Well, is that a physical injury? Yes, it is. Therefore, the $250,000 is tax free. However, the punitive damages is not tax free. It's taxable. What should you do now? Go to the FARHAT lectures, look at additional resources to understand what's included in income, gross income inclusion, gross income execution. Those topics are important. We're focusing here on what is executed gross income execution, but there's always exception to that gross income execution. It becomes gross income inclusion. Just multiple additional multiple choice true, false and additional resources will help you see the big picture. If you're studying for your CPA exam, enrolled agent, or an accounting student, FARHAT lectures is your answer. Good luck, study hard, and of course, stay safe.