PLR Article

Recent PLR Article

Excludability from Gross Income of Bad Faith Claim Transfer to Settle Personal Injury Claim

There has long been confusion over the issue of taxability of derivative claims in cases involving personal injury. What is clear is that claims arising specifically out of personal physical injury or illness are exempt from federal taxation. However, what happens when an insurance company fails, in bad faith, to settle a claim on an insured’s liability policy arising from a victim’s personal injury judgment? Can the defendant assign his bad faith claim to the personal injury victim as a means of satisfying the judgment rendered against him? If so, what are the personal income tax consequences of settlement of this ancillary suit, since it is not against the defendant for personal injury damages, but rather against the defendant’s insurance carrier for bad faith failure to settle the claim?

A recent Private Letter Ruling from the I.R.S. highlights the exclusion from gross income of settlement proceeds arising from a bad faith claim transfer that is related to a personal physical injury award of damages (PLR 200903073).

In this case a highway construction worker was hit and rendered quadriplegic by a drunk driver. The driver, a tavern manager, became intoxicated while on duty. The victim brought a tort action and was awarded compensatory and punitive damages. Prior to the judgment, 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. In order to stay execution of the victim’s judgment against the assets of the driver and the tavern, the bad faith claim was transferred to the plaintiff via assignment agreement. Upon settlement with the insurance company, plaintiff agreed the judgment would be satisfied and all remaining litigation dismissed.

Following the wrap up of the suit the question of whether to tax the settlement proceeds was raised. The IRS concluded that since 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. This exclusion from gross income applies only to the degree the proceeds cover the settlement of non-punitive damages.

So, to the extent that the settlement of a bad faith claim against a defendant’s insurance company is assigned to a claimant in lieu of a judgment against the defendant, the award can be received tax free. This is clearly a beneficial ruling for injury victims caught in this protracted situation wherein questions of taxability threaten to jeopardize part of their recovery.¬†Click here to download a copy of the Private Letter Ruling.